Information on Options Theta

 

If XYZ were trading $50 and a 50 strike call was trading at $3 with a Theta of, an investor would anticipate that option to lose about $ per day, all things being equal. If a day passed without a change in the option price, then one of .

That is, it doesn't matter whether you have the option to buy or sell the stock; that option becomes worth less each day that passes. This is because the time value premium on these options are higher and so they have more to lose per day. So, increasing the volatility increases Theta and decreasing volatility decreases Theta.

More Time vs Time Decay

Theta, which is more commonly referred to as time decay, describes the rate at which the value of an option will erode as one trading day passes. This of course assumes that all other inputs are unchanged.

The theta value is the Greek which indicates how the price of an option changes as the expiration date gets closer and closer. The extrinsic value of an options contract will diminish over time as the expiration date of that contract approaches, due to the effects of time decay, and Theta is basically an estimated measurement of the rate at which this happens.

In theory, theta value will tell you how much the price of an option will depreciate on a daily basis. On this page we provide details on the characteristics of this Greek and explain how you can use it.

The theta value of an option essentially shows the dollar amount at which the price of an option will fall each day, assuming all other factors remain equal. An option with a theta value of -. One with a theta value of -. Calls and puts both have negative theta values, because they both lose extrinsic value over time due to time decay. It's worth noting, though, that if you write options to take up a short position on them, then theta will work in your favor. When you own options contracts, time decay has a negative impact on the value of the contracts that you own, but when you are short on options the effect of time decay is a positive impact.

There are two main factors which influence theta value: Also, the price of near-term at-the-money options will change more significantly than the price of longer-term at-the-money options.

So what this talk about gamma boils down to is that the price of near-term at-the-money options will exhibit the most explosive response to price changes in the stock. But if your forecast is wrong, it can come back to bite you by rapidly lowering your delta.

But if your forecast is correct, high gamma is your friend since the value of the option you sold will lose value more rapidly. Time decay, or theta, is enemy number one for the option buyer. Theta is the amount the price of calls and puts will decrease at least in theory for a one-day change in the time to expiration.

Notice how time value melts away at an accelerated rate as expiration approaches. In the options market, the passage of time is similar to the effect of the hot summer sun on a block of ice. Check out figure 2. At-the-money options will experience more significant dollar losses over time than in- or out-of-the-money options with the same underlying stock and expiration date. And the bigger the chunk of time value built into the price, the more there is to lose.

Keep in mind that for out-of-the-money options, theta will be lower than it is for at-the-money options. However, the loss may be greater percentage-wise for out-of-the-money options because of the smaller time value.

Obviously, as we go further out in time, there will be more time value built into the option contract. Since implied volatility only affects time value, longer-term options will have a higher vega than shorter-term options. Vega is the amount call and put prices will change, in theory, for a corresponding one-point change in implied volatility.

Typically, as implied volatility increases, the value of options will increase. Vega for this option might be. Now, if you look at a day at-the-money XYZ option, vega might be as high as. Those of you who really get serious about options will eventually get to know this character better. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.

Note, I have bought this package myself so I know from experience what is inside the course. Generally speaking, long positions will have negative Theta and short positions have positive Theta, however, not always.

A good example that breaks this rule is a long calendar spread. The net premium for this strategy will most likely be a debit i. So, this position is called a long spread. However, the Theta for this strategy will most likely be positive as the shorted dated options will have a higher rate of decay than the longer dated expiry. Remember that the Theta defines the rate of change when all other inputs remain unchanged.

Movements in price and the effect the movement will have on the probability of the option is called Gamma. Option gamma is another Greek calculation that defines the rate of change of the option delta as the underlying moves 1 full point. Gamma has an inverse relationship to Theta. If your Theta is negative, you will want your position to experience a strong underlying price movement, hence a positive Gamma.

Conversely, if your position Theta is positive you will benefit as the underlying price remains constant and lose value if the market moves hence a negative Gamma. Technically speaking, Theta is the first order derivative of the value of the option price and is the output of an option pricing model. There are a number of calculators that you can use to price options including my own option pricing spreadsheet.

The Visual Basic formula used in my spreadsheet calculates Theta from the Black and Scholes method as;. A covered call strategy is a low risk way to profit from time value decay.

If the vega is high then the implied volatility will also be high and you can sell with a high option value. To make the most decay the delta ratio of option value with respect to changes in the underlying of a call should be close to 50 to capture the most amount of time decay.

The graph is of the Option Price. But because the graph is dealing with an OTM option the Time value and the Option Price are the same thing because there is no intrinsic value. I hope that makes it clearer for you. Nope, it is the price of the option. I generated that graph by plotting the theoretical price of an OTM option and just changed the time to expiry until it was zero. If it was an ITM option, the graph would be very similar except instead of falling at zero at zero days it would settle at the intrinsic value of the option.

Excuse me, but in the graph it isn't the "Option Price" but the time value of the option! Good Explanation, but theta can have positive value as well and negative values. Theta is always negative for long position positive one for short position. Theta is always positive for long position and negative one for short position.