Over the last month we have discussed the main options Greeks that an option trader should look at. We started with delta and gamma, which are related to the change in the option price due to changes in the underlying price. After that, we explored vega and rho, which relate the price of an option to implied volatility and interest rates, respectively. In this article we conclude the series by examining a fifth Greek — theta.
Theta is an important measure and is quite simple to understand. It gives you an idea of how much you will lose by holding an option one more day. Theta measures the expected dollar amount change in an option when time to maturity decreases by one day. As you know, an option’s value consists of two parts: intrinsic value, derived from the difference between the strike and underlying prices, and extrinsic value, which relates to volatility. As time passes, more and more of the stock price path becomes known and thus reduces uncertainty, until the maturity date, when prices are known and uncertainty simply vanishes. So, as time to maturity approaches (as time goes on), the extrinsic value of an option drops. Vega measures this influence.
Let’s look at an example of theta to understand how it works. Assume theta is -0.25 and an option is valued at $2.70. If all other factors remain unchanged, your option will be worth $0.25 less, or $2.45, tomorrow.
As you probably already suspected, theta is always negative. An option premium, whether it’s a call or put, declines in value over time (or at least doesn’t rise). This makes theta an enemy of the option’s buyer. If all other factors remain the same, you will lose money by holding the option, and if it’s an out-of-the-money option, the loss is total. But this also means theta is an ally of the option’s seller. The increasing rate of decay as time to maturity approaches entices option traders to engage in strategies that involve selling out-of-the-money options. As time passes, the price of the option quickly drops and they are able to collect the premium.
Theta is higher for at-the-money options than it is for out-of-the-money and in-the-money options. The concept behind it is simple: When an option is deep in-the-money or out-of-the-money, its extrinsic value is relatively small. Time isn’t an important part of value for these options. But time is everything for an at-the-money option, which has a flat intrinsic value and thus is highly sensitive to time decay.
That’s it for option Greeks. Be sure to study them before trading options — they can guide you to profitable trades and help you avoid unexpected situations.
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