In options trading, the price of an option (known as its premium) is sensitive to the passage of time. As the time to expiration nears, this time-value of the option decreases, making an option on the same underlying asset more expensive as its maturity increases (all else being equal). This "time decay" works at different speeds for options of different maturities or strike prices. As a result, credit spreads—where one option is sold at a greater premium and simultaneously another option is purchased at a lower premium—will also experience the effects of time on its price.
- A credit spread involves selling a high-premium option while purchasing a low-premium option in the same class or of the same security, resulting in a credit to the trader's account.
- Options contracts are derivatives that generally experience time decay (i.e., tend to lose value as time passes).
- Theta is the options risk factor that describes its price-sensitive to the passage of time.
- Credit spreads naturally carry a positive theta, meaning they benefit from the passage of time.
What Is Theta?
Theta is the name for the risk metric that measures the rate of change in an option's value concerning the passage of time. If an option's theta is, say, $0.10, then its premium will decline, or experience time decay, of ten cents per day, holding everything else constant. Owners of long options positions would thus experience a negative effect from theta as they continue to hold on to their options contracts. Sellers of options (known as "writers"), on the other hand, can benefit from time decay and receive positive theta.
Of course, sellers of options are exposed to several other risk factors that can negate the positive effect of their theta position—for instance, if the price of the underlying moves significantly or if implied volatility rises. However, certain options strategies known as spreads, can capitalize on positive theta while mitigating the extent of some of those other risks.
Theta and Credit Spreads
A credit spread is an option trading strategy that involves simultaneously buying a lower premium option and writing a higher premium option in the same underlying asset with the same expiration date.
Note that the term "credit spread" can also be used in assessing the yield of a bond over a Treasury. Here, we look only at its meaning in terms of options trading.
This kind of trade yields a net credit when opening the position and profits if the spread narrows. Because there is both a long leg and short leg in the spread, the overall riskiness of the short position is somewhat offset by the long. Still, since this is a net short position, the overall theta of the strategy is positive. The position thus appreciates in value as the expiration date gets close as long as the underlying asset stays put.
For instance, a bearish trader expects who stock prices to decrease could buy call options (long call) at a certain strike price and sell (short call) the same number of call options within the same class and with the same expiration at a lower strike price. If the price of the underlying does in, fact, fall the writer of the spread benefits. But, if the price of the underlying remains where it is and doesn't move much at all by expiration, the writer still benefits from the positive theta.
For example, say an investor buys one call option on XYZ shares with a strike price of $30 for $1 in premium and simultaneously writes a second call option with a strike price of $25 and collects a premium $4. The net credit received is $3 ($4 - $1), or $300, since an equity option has a multiplier of 100. The net credit is the maximum profit the investor can receive.
Now, suppose the theta of the overall position is 0.20. This means that the spread earns $20 per day for our investor, if all things remain equal. In this case, the investor is betting that the time decay of the position will increase and that the stock price will remain below $25 by expiration.