The Option Greeks - Theta
What Is Theta And How Does It Effect Option Prices?
When it comes to options trading or investing, one cannot become successful without a thorough understanding of the option Greeks.
These greeks include delta, theta, gamma, rho, vega, and more.
It is imperative to understand not only each greek but how they relate to one another.
Because an option is a wasting asset, one must understand and account for theta when using options to initiate a position.
What Is Theta And How Does It Effect Options?
Options are wasting assets.
They have a finite lifespan.
Every listed options contract will have a set expiration date.
Because options expire, the window of opportunity for an option to go into-the-money goes down with each passing day.
This is the greek theta at work.
Theta is the estimate of how much value an option will lose per day when there are no changes in the underlying price or its volatility.
When it comes to option values, options have two types of value.
Intrinsic and extrinsic.
Intrinsic value applies to options that are in-the-money.
An example of this would be a $400 call option on Apple trading at $100 when Apple shares are at $500.
The call is $100 in-the-money and therefore has $100 of intrinsic value.
A $600 call option on Apple may be trading at only $10 per option with Apple trading at $500 per share.
This $10 per option represents extrinsic, or time value.
A simple way to think of theta is opportunity cost.
When looking at option greeks, theta is expressed as a point value.
Theta is always highest for at-the-money options and is progressively lower for deep in-the-money options as well as deep out-of-the-money options.
When looking at an option position, long call options and long put options are always theta negative while short call options and short put options are always theta positive.
What this essentially means is that the power of time works against an option buyer and works for an option seller.
Options with more time remaining until expiration will have lower rates of theta than options with less time.
This rate of time decay of an option accelerates when the option has 30-60 days remaining until expiration and is exponential meaning the closer the option gets to expiration the faster it decays.
How Do Traders Or Investors Use Theta?
Theta considerations are a key component of an options position.
When one is looking to buy or be long options, it is critical to take the effects of time decay into account.
This is precisely how many new options traders lose money.
They may prove to be right about the market or the stock, but their timing may have been off and they lost money through the time decay of the option or the option expired worthless before their market forecast materialized.
When buying options, one must be right about time, volatility, and market direction if buying a directional position.
Many traders and investors try to utilize theta to their advantage by selling options.
When one sells an option, the position is theta positive, meaning that all else being equal the option will lose value on a daily basis with no changes in the underlying.
This is precisely what the option seller wants.
Often times, option sellers look to collect theta without having a directional bias in the underlying market.
Option selling is an advanced strategy however, and should not be undertaken by anyone without a deep understanding of options and the risks involved in selling options.