What is Theta in Options Trading – What Is Theta?
Theta in Options Trading: The term theta for options trading 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. Of course, this assumes that everything else is held constant. Theta is generally expressed as a negative number. It can be thought of as the amount by which an option’s value declines every day. Theta is useful in assessing an option’s value in relation to the time until expiration. The metric can be thought of as the rate of decline in the value of an option as time passes. Theta can help to assess how much the underlying asset must change in value to offset the value lost to time decay.
To summarize, theta refers to the rate of decline in the value of an option over time. If all other variables are constant, an option will lose value as time draws closer to its maturity. Theta is usually expressed as a negative number. It indicates how much the option’s value will decline every day up to maturity.
Theta in Options Trading – A Deeper Look
As part of the group of measures known as the Greeks, theta is used in options pricing. Options give the buyer the right to buy or sell an underlying asset at the strike price before the option expires. The strike price is also called an exercise price and is set when the contract is first written. It informs 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. This is because options can only be exercised for a certain period of time. The concept is known as time decay or the erosion of the value of an option as time passes. As a result, an option’s profitability decreases as time goes on.
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. This is because there is a greater chance or more time that the option could move beyond the strike price.
Theta represents the risk of time and the loss of value of an option. Therefore, 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.
What is Theta in Options Trading Used for?
As stated above, theta is used to gauge the sensitivity of the option value to time. It can be used to see how much value an option loses on a daily basis. Also, how much the underlying asset will need to change to offset the loss in according to theta. The measurement is not used by traders as often as other measures such as delta. However, buyers may still want to know what to expect in terms of time changes to an option. Option writers who take a short position may consider theta since they will benefit from the time decay.
Theta or time decay is not linear. The theoretical rate of decay will tend to increase as time to expiration decreases. Thus, the amount of decay indicated by Theta tends to be gradual at first and accelerates as expiration approaches. Upon expiration, an option has no time value and trades only for intrinsic value, if any. Pricing models take into account weekends, so options will tend to decay seven days over the course of five trading days. However, there is no industry-wide method for decaying options so different models show the impact of time decay differently. If a pricing model is decaying options too quickly, current markets may look too high when compared to the model’s theoretical values, and if the model is displaying the decay as too slow, the current markets may look too cheap compared to your model’s theoretical values.
How Theta in Options Is Calculated
Theta is represented in an actual dollar or premium amount and may be calculated on a daily or weekly basis. It’s important to keep in mind that it’s not a hard and fast measure of an option’s value. It’s all theoretical. Theta assumes that price movements and volatility are ongoing. Therefore, the rate of time decay for an option isn’t necessarily the same from one day to the next.
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 values 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.
Theta time decay
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 zero, 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 calculation of theta is expressed as a yearly value; however, the figure is often divided by the number of days in a year to arrive at a daily rate. The daily rate is the amount the value will drop by.
A theta of -0.20 means that the price of an option would fall by $0.20 per day. In two days’ time, the price of the option would’ve fallen by $0.40. However, it is important to note that theta is not constant over the lifetime of the option. As the option gets closer to the expiration date, theta increases, and the value lost to time decay picks up.
At-the-Money vs. In-the-Money vs. Out-of-the-Money
At-the-money, in-the-money, and out-of-the-money are three other relevant options terms. All three tie into time decay and its impact on an option’s value. When an option is at-the-money or ATM, it means the option’s strike price–or the price at which the option can be bought and sold–is the same as the price of the underlying security. In-the-money, or ITM, for an equity call contract, means its strike price is less than the current underlying stock price. Equity put contracts are in-the-money when their strike price is greater than the current underlying stock price. An option that’s out-of-the-money, or OTM, for call options, means the strike price is higher than the underlying asset’s market price. Again, with put options, it’s the reverse; the strike price is lower than the asset’s market price.
So, what does this all have to do with Theta? What does it mean for options traders looking to turn a profit? The Theta value is usually at its highest point when an option is at-the-money, or very near the money. As the underlying security moves further away from the strike price, meaning the option is going into-the-money or out-of-the-money, the Theta value gets lower.
- ITM – If an option is In-The-Money at expiration, investors could profit with call options because the market price is higher than the strike price. It would be the reverse with in-the-money put options.
- OTM – An investor with Out-of-The-Money options would need to sell before the expiration date to maintain any profit. ATM options also have no intrinsic value but they can potentially shift to ITM with a longer window until expiration.
Theta Options – 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 favorable 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.
Theta Options vs. Other Greek Measures
The Greeks measure the sensitivity of options prices to their respective variables. For instance,
- The Delta of an option indicates the sensitivity of an option’s price in relation to a $1 change in the underlying security. Delta is a measure of the change in an option’s price (that is, the premium of an option) resulting from a change in the underlying security. The value of delta ranges from -100 to 0 for puts and 0 to 100 for calls (-1.00 and 1.00 without the decimal shift, respectively). Puts generate negative delta because they have a negative relationship with the underlying security—that is, put premiums fall when the underlying security rises, and vice versa.
- The Gamma of an option indicates the sensitivity of an option’s delta in relation to a $1 change in the underlying security. Gamma measures the rate of changes in delta over time. Since delta values are constantly changing with the underlying asset’s price, gamma is used to measure the rate of change and provide traders with an idea of what to expect in the future. Gamma values are highest for at-the-money options and lowest for that deep in- or out-of-the-money.
- Vega indicates how an option’s price theoretically changes for each one percentage point move in implied volatility. Vega measures the risk of changes in implied volatility or the forward-looking expected volatility of the underlying asset price. While delta measures actual price changes, vega is focused on changes in expectations for future volatility.
Drawn from the Greek alphabet, theta has numerous meanings across different fields—in economics, it also refers to the reserve ratio of banks in economic models.
Example of Theta in Options Trading
Let’s assume an investor purchases a call option with a strike price of $1,150 for $5. The underlying stock is trading at $1,125. The option has five days until expiration and theta is $1. In theory, the value of the option drops $1 per day until it reaches the expiration date. This is unfavorable to the option holder. Assume the underlying stock remains at $1,125 and two days have passed. The option will be worth approximately $3. The only way the option becomes worth more than $5 again is if the price rises above $1,155. This would give the option at least $5 in intrinsic value ($1,155 – $1,150 strike price), offsetting the loss due to theta or time decay.
Day trading is simply buying a stock or security, then, quickly selling or closing out the position. Usually, the position is closed within a single trading day. Ideally, a day trader wants to “cash-out” by the end of each trading day. They want no open positions to avoid the risk of losses by holding security overnight. Day trading is not for everyone and carries significant risks. It requires an in-depth understanding of how the markets work and various strategies for profiting in the short term. Short term profits require a very different approach compared to traditional long term, buy and hold investment strategies.