What Is Theta?
Theta, or theta decay, is one of the four major “greeks” of options derivatives. The “greeks” all affect the premium of an option contract differently. Theta, represents the rate at which an option contract loses value as time passes. As a result of theta, an option contract loses value as it gets closer to maturity.
Why Do Options Lose Value From Theta?
Because option contracts expire, investors run the risk of loss if they cannot exercise their contract before expiration. As time moves closer the the options maturity, this risk becomes greater. This risk is priced into option securities via theta.
How To Analyze Theta For Options
Because of the value that is lost overtime, theta is expressed as a negative number. So, for the long side of an option trade, theta will decrease the value of their position. However, the seller of an option contract’s position increases as theta takes value from the buyer. It is important for option traders to know that theta is not constant. As contracts approach maturity, theta accelerates, decreasing the value of a contract quicker and quicker until it goes to zero.
How Does Theta Work?
As mentioned before theta is represented as a negative number. This number is the amount of value a contract will lose per day as it nears maturity. Let us say somebody purchases a call option for $10.00. The theta on this contract is -0.20. This means, that if all else is completely constant, the contract will only be worth $9.80 the next day. As this contract approached maturity, however, the theta would increase, taking more and more value from the call option each day.
Why Is Theta A Threat To Traders?
Unfortunately for traders, theta greatly complicates options trading. Hypothetically, a trader could correctly predict price movement on an underlying security but still lose money trading an option as a result of theta decay. In conclusion, if you are going to trade options, it is important to take a close look at the theta before you purchase your contracts.
Theta Decay
Theta decay is represented as a negative number because the value of the option decreases over time. The rate of theta decay is affected by several factors including the time to expiration, the volatility of the underlying asset, and the strike price of the option. The rate of theta decay is typically higher for options with a shorter time to expiration and is more significant for options that are out of the money.
The impact of theta decay is an important consideration for options traders. If an options trader purchases an option with a short time to expiration, they must be aware of the rate of theta decay and the potential impact on the value of their investment. Options traders can use options pricing models to calculate the expected rate of theta decay and incorporate it into their trading strategy.
Theta decay can also be used as a strategy for options traders. Options traders can sell options with a short time to expiration and benefit from the rate of theta decay. This strategy is often referred to as “selling theta” or “selling time.” By selling options with a short time to expiration, options traders can generate income from the rate of theta decay and take advantage of the natural decline in the value of the option.
In conclusion, theta decay is a critical concept in options trading. It refers to the rate at which the value of an option declines as it approaches its expiration date. Theta decay is a measure of the impact of time decay on the value of an option and is affected by several factors including time to expiration, volatility, and strike price. Options traders must be aware of the rate of theta decay and use it to inform their trading strategy. Theta decay can also be used as a strategy for options traders looking to generate income from selling options with a short time to expiration.
