Theta, one of the five greeks used for measuring options risk, measures the rate of decline of the time premium (the effect on the option's price of the time remaining until option expiration) with the passage of time. The measure of theta quantifies the risk that time imposes on options as options are only exercisable for a certain period of time. Understanding premium erosion due to the passage of time is critical to being successful at trading options. Often, the effects of theta will offset the effects of delta, resulting in the trader being right about the direction of the move and still losing money. Theta can also be referred to as the time decay on the value of an option.
If everything is held constant, the option will lose value as time moves closer to the maturity of the option. The decay in the time value of an option accelerates as the option gets closer to expiration with the majority of time value present in an option eroding during the 30 days before expiration (Figure 1).
Long options and option positions have negative theta and short options and option positions have positive theta.
If an option or option position has a theta of 3.54, then the position gains $3.54 per day.
(Remember that options are bought or sold in blocks of 100, but option prices and option greeks concern only 1 option. So if you purchase 1 IBM JUL08 120 option contract for $3.10 with a theta of -.10, this option will cost you $310 and the time value of the option will decline at $10 per day (theta = -.10*100 = -10.))