Trying to predict what will happen to the price of a single option or a position involving multiple options as the market changes can be a difficult undertaking. Because the option price does not always appear to move in conjunction with the price of the underlying asset, it is important to understand what factors contribute to the movement in the price of an option and the effect they have.
Options traders often refer to the delta, gamma, vega, and theta of their option positions. Collectively, these terms are known as the Greeks, and they provide a way to measure the sensitivity of an option's price to quantifiable factors. These terms may seem confusing and intimidating to new option traders, but broken down, the Greeks refer to simple concepts that can help you better understand the risk and potential reward of an option position.
What Is Theta?
The term theta refers to the rate of decline in the value of an option due to the passage of time. It can also be referred to as the time decay of an option. This means an option loses value as time moves closer to its maturity, as long as everything is held constant. Theta is generally expressed as a negative number and can be thought of as the amount by which an option's value declines every day.
Understanding Theta
Theta is part of the group of measures known as the Greeks, which are used in options pricing. Remember—options give the buyer the right to buy or sell an underlying asset at the strike price before the option expires. The strike price, which is also called an exercise price, is set when the contract is first written, informing the investor of the price at which the underlying asset must reach before the option can be exercised.
The measure of theta quantifies the risk that time poses to option buyers since options are only exercisable for a certain period of time. This is known as time decay or the erosion of the value of an option as time passes. An option's profitability decreases as time goes on. But what happens when two options are similar but one expires over a longer period of time? The value of the longer-term option is higher since there is a greater chance or more time that the option could move beyond the strike price.
Because theta represents the risk of time and the loss of value of an option, it is always expressed as a negative figure. The value of the option diminishes as time passes until the expiration date. Since theta is always negative for long options, there will always be a zero-time value when the option expires. This is why theta is a good thing for sellers but not for buyers—value decreases from the buyer's side as time goes by, but increases for the seller. That's why selling an option is also known as a positive theta trade—as theta accelerates, the seller's earnings on their options increase.
All options – both Calls and Puts lose value as the expiration approaches. The Theta or time decay factor is the rate at which an option loses value as time passes. Theta is expressed in points lost per day when all other conditions remain the same. Time runs in one direction, hence theta is always a positive number, however, to remind traders it’s a loss in options value it is sometimes written as a negative number. A Theta of -0.5 indicates that the option premium will lose -0.5 points for every day that passes by. For example, if an option is trading at Rs.2.75/- with a theta of -0.05 then it will trade at Rs.2.70/- the following day (provided other things are kept constant). A long option (option buyer) will always have a negative theta meaning all else equal, the option buyer will lose money on a day-by-day basis. A short option (option seller) will have positive theta. Theta is a friendly Greek to the option seller. Remember the objective of the option seller is to retain the premium. Given that options lose value on a daily basis, the option seller can benefit by retaining the premium to the extent it loses value owing to time. For example, if an option writer has sold options at Rs.54, with a theta of 0.75, all else equal, the same option is likely to trade at – =0.75 * 3 = 2.25 = 54 – 2.25 = 51.75 Hence the seller can choose to close the option position on T+ 3 day by buying it back at Rs.51.75/- and profiting Rs.2.25 …and this is attributable to theta!
How to Interpret Theta?
To understand theta, it is important to first understand the difference between the intrinsic and extrinsic value of an option. Together, the extrinsic and intrinsic value make up the total value or premium of an option. The intrinsic value only measures the profit of the option based on the strike price and market price. One way to think about the intrinsic value is that if the option were to expire today, the premium consists only of this intrinsic value (strike price – market price). The extrinsic value, on the other hand, measures the part of the premium not defined by the intrinsic value. The extrinsic value is the value of being able to hold the option and the opportunity for the option to gain value as the underlying asset moves in price. The closer an option is to expiration, the smaller the extrinsic value becomes.
We now know that the further away from expiration the option is, the higher the extrinsic value. The closer to expiration the option is, the smaller the extrinsic value. At the expiration date, the extrinsic value is 0, and the entire premium consists of the intrinsic value assuming the option is in the money. Theta is a sensitivity measure that determines the decline in this extrinsic value of the option over time.
The Theta Curve
As mentioned above, Theta is not linear. That is to say; the affect Theta has on an option's price is not straightforward and does not reduce an option's price by the same amount with every passing day.
The effect Theta has on an option's price is not straightforward. It does not reduce the price by the same amount throughout the life of the contract. As the days pass, an option has less time to make a move, and thus it will be worthless.
Let's take a second to think about this. If an option has 100 days till expiration, that is an eternity for it to make a move so that that option would be more expensive. Contrarily, if an option expires tomorrow, then the time to make a move is very limited, and the value of that option will be low.
When an option's time to expiration is under 20 days, the amount of Theta begins to increase exponentially. This is worth noting, and if you are long options near expiration, you will be fighting an uphill battle against time. On the other hand, if you are short options near expiration, time will be your new best friend.
Special Considerations
If all else remains equal, the time decay causes an option to lose extrinsic value as it approaches its expiration date. Therefore, theta is one of the main Greeks that option buyers should worry about since time works against long option holders.
Conversely, time decay is favourable to an investor who writes options. Option writers benefit from time decay because the options written become less valuable as the time to expiration approaches. Consequently, it is cheaper for option writers to buy back the options to close out the short position.
Put a different way, option values are, if applicable, composed of both extrinsic and intrinsic value. At option expiration, all that remains is intrinsic value, if any, because time is a significant part of the extrinsic value.
Conclusion
Time may be flying, but now you can put it on your side. By understanding Theta, you know it will have an adverse effect on your long positions and a positive impact on your short positions. You now know when options have accelerated time decay, which allows you to take the right strategy at the right time. Remember, there is no edge in trading options over the weekend, and volatility can negate time decay, especially around an earnings announcement.
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