Theta: What’s the Time Decay in Options Trading?

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Theta: What Is It?

The pace at which an option’s value decreases over time is referred to as theta. It may also be known as an option’s time decay. Assuming no changes, an option loses value as the time approaches the maturity date. Theta typically stated as a negative number, can be thought of as the daily drop in the value of an option.

KEY LESSONS

  • Theta describes the pace at which an option’s value decreases over time.
  • If all other factors remain constant, an option will depreciate as it approaches maturity.
  • Theta, often written as a negative number, represents the amount the option’s value will decrease each day until it expires.

Identifying Theta

Theta is a member of the collection of metrics referred to as the Greeks applied to options pricing. Remember that when purchasing an option, the buyer is given the right to purchase or sell the underlying asset at the strike price before the option expires. When the contract is created initially, the striking price, also known as the exercise price, is established. It informs the investor of the price that the underlying asset must reach before the option may be exercised.

Because options may be exercised only for a specific amount of time, theta measures the risk that time presents to option purchasers. This is referred to as time decay or the erosion of an option’s value over time. The profitability of an option declines with time. What transpires, though, when two options are comparable, but one expires over a longer period? Because there is a larger likelihood or more time for the option to go beyond the strike price, the value of the longer-term option is higher.

Theta is usually a negative number since it stands for the danger of time and the potential loss of an option’s value. As time moves closer to the option’s expiration date, its value decreases. The time value at expiration will always be zero since theta is always negative for long options. The value diminishes from the buyer’s perspective with time but grows for the seller, which is why theta is beneficial for sellers but bad for purchasers. Because the seller’s gains on their options grow as theta accelerates, selling an option is sometimes referred to as a positive theta transaction.

If all else is equal, an option loses extrinsic value as it gets closer to its expiration date due to time decay. Given that time is on the side of holders of long options, theta is one of the key Greeks that option purchasers should be concerned about.

On the other hand, time decay benefits an investor who writes options. Time decay is advantageous to option writers because as the time to expiry draws near, the written options lose some of their value. As a result, buying back the options to cover the short position is more cost-effective for option writers.

In other words, option values, if any, are made up of both intrinsic and extrinsic values. Because time is a substantial component of extrinsic value, all left upon option expiry is intrinsic value, if any.

Greeks other than Theta

The Greeks gauge how sensitive option prices are to various circumstances. For example, an option’s gamma shows how sensitive an option’s delta is to a change of $1 in the underlying security. In contrast, an option’s delta shows how sensitive an option’s price is to a change in the underlying security.

Vega is the theoretical change in the price of an option for each percentage point change in implied volatility.

Theta, derived from the Greek letter, has multiple connotations in various disciplines, including economics, where it also alludes to the reserve ratio of banks in economic models.

Examples of Theta

Assume a trader pays $5 for a call option with a $1,150 strike price. The price of the underlying stock is $1,125. Theta is $1, and the option expires in five days. The option’s value is supposed to decrease by $1 daily up to the expiration date. This is not to the option holder’s advantage.

  • Assume two days have passed, and the underlying stock is still trading at $1,125. The value of the option will be about $3. The choice is only worth more than $5 once again if the cost exceeds $1,155. This would cover the loss from theta or time decay and provide the option of at least $5 in intrinsic value ($1,155 – $1,150 strike price).
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