A Peek At Theta3 min readReading Time: 2 minutes
What Is Theta?
Theta is the Greek that explains the relationship between the price of an option and the time to expiry.
The extrinsic value i.e. non-intrinsic value of an option diminishes over time as the option approaches maturity. This is because of time decay. Theta is the rate at which this time decay happens. Theoretically, Theta explains how the price of an option decays daily.
Let us take an example. An option with a Theta value of -0.05 would lose Rs. 0.05 each day from its price as expiration date nears.
Theta For Calls & Puts
Theta is negative for both calls and puts because both calls and puts lose extrinsic value over time due to time decay. So, when one writes options to take up a short position on them, Theta works in the favor. However, Theta works against one when one own options.
Factors That Affect Theta
There are two important factors that influence the value of Theta.
The value of Theta is at its highest when an option is at the money, or very near the money. As the underlying security moves further away from the strike price i.e. the option becomes deep in the money or out of the money, the Theta value becomes lower.
A deep-in-the-money or out-of-the-money option would have less extrinsic value to decay because the price would be made up mostly of the intrinsic value. Therefore, the rate of decay would be lower.
2. Time to Expiry
The length of time until expiry also plays a role as the effect of time decay increases as we come closer to maturity. This means that the Theta value usually gets higher as the maturity comes closer except for deep out-of-the-money options.
When To Use Theta
Theta is useful for trading strategies in a neutral market. This is because these strategies are used to make a profit out of the effects of time. While using such strategies, it is important that the overall Theta of the position is kept at the appropriate level so that one can extract the diminishing extrinsic value.
Traders expecting to profit from significant directional moves in underlying securities or are planning to hold positions all the way through to maturity need not worry about Theta. The loss of extrinsic value in such trades is a direct cost of making the trade and should be offset by relevant directional moves that the trader is expecting to happen.
Theta is very relevant to traders who are expecting to profit from positions with small directional movements in underlying securities over a relatively short period of time. Ideally, if a trader is speculating on small movements, they would want to be trading options that have low Theta values so that the effect of time decay doesn’t wipe out any profits that they make from those small directional moves.
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