Introduction

Theta is a measure of the daily rate of change in an option's premium as that option's expiration date draws near. As the contract's expiration date approaches, the rate of time decay increases, and this increase is represented by the Theta value. Investors use Options Theta to mitigate market risk when trading options by revealing the impact of time decay on an option's price. Theta helps sellers of options contracts because as time passes, the value of the option declines and the probability of the buyer exercising the option drops. That's why options sellers tend to favour contracts with a high Theta.

How Theta Works

Theta is typically a negative number because options depreciate as the expiration date approaches. Consequently, if the value of Options Theta is -0.40, the options contract will lose about $0.40 daily. A daily loss of $0.40 would amount to about $40 ($0.40 x 100 = $40) because options contracts typically grant the investor the ability to buy or sell 100 shares of the underlying asset. Say, for instance, you are evaluating two XYZ Company options contracts. You want to know when it's best to buy options on XYZ Company, and you know that the type of option whose value declines more slowly as its expiration date approaches is the one you should go for.

However, the loss of value through time cannot be measured in a straight line. In other words, the faster time passes, the more money an option loses every day owing to time decay, as measured by the rate at which its Theta increases. If an option is in the money (ITM), at the money (ATM), or slightly out of the money (OTM), its Theta will rise as its expiration date approaches. However, with very out-of-the-money options, Theta typically declines as expiration approaches.

Theta vs Other Greeks

The Greeks quantify how much different factors affect the prices of options. An option's delta represents its price's sensitivity to a $1 change in the underlying security, and an option's gamma does the same for the delta's sensitivity to a $1 change in the underlying security. How much an option's price might fluctuate hypothetically for every percentage point change in implied volatility is represented by Vega. The Greek letter Options Theta serves as a jumping-off point for many diverse interpretations; for example, in economics, Theta might stand for the bank reserve ratio.

Example of Theta

Imagine a trader paying $5 to enter a call option with a $1,150 strike price. Presently, the underlying stock price is $1,125. The choice has a $1 theta and a remaining life of 5 days. Theoretically, the option's value will decrease by one dollar per day until the date it expires. The holder of the option is going to be negatively affected by this. The underlying stock is still worth $1,125 after two days, and the price hasn't changed. Roughly $3 is how much the option will be worth. Only if the price goes above $1,155 does the option become worth more than $5 again. Thus, the loss from Theta or temporal decay would be cancelled out by at least $5 in intrinsic value ($1,155 - $1,150 strike price).

What It Means for Individual Investors

One of the primary distinctions between equity and option investments is that options have a finite life span. As a result, wasting any time can significantly cut into your earnings. Possessing knowledge of available choices With the help of Theta, you may regulate the temporal decay of an option and make strategic decisions as the option's expiration date approaches.

Alternatives to Theta

Options contracts can also be analyzed using the other four Greek metrics of Delta, Gamma, Vega, and Rho, in addition to Theta.

• Delta measures how much the price of a contract for options will shift in response to a shift in the cost of the underlying asset.
• Gamma is the rate at which the value of an option would fluctuate in response to a change in the value of the underlying asset.
• Vega indicates how much an option's strike price will fluctuate in response to a change in the underlying asset's implied volatility.
• RHO indicates how much a change in interest rates will affect the value of an option.

Conclusion

The time decay of an option causes it to lose extrinsic value as the option's expiration date approaches, assuming all other factors remain constant. Since time is always against long option holders, Theta is an important Greek for option buyers to consider. But for the investor who makes money by penning options, time decay is a friend. Because the value of options written decreases as the time nears expiration, time decay is advantageous to option writers. Therefore, option writers can save money by closing their short position by purchasing the options back at a discount.