Basics Of Options
Thirdly, we will discuss ‘Theta’.
What is theta?
Theta is a measure of the rate of decline in the value of an option due to the passage of time. Theta is generally expressed as a negative number and can be thought of as the amount by which an option's value will decline every day.
We know, Premium = Intrinsic Value + Time Value
Intrinsic value is always a positive value or zero and can never be below zero. It’s a relationship between spot price and strike price.
Time value is what is being charged on account of passage of time and volatility. Time as we know moves in one direction.
Keeping the expiry date as the target time, as time progresses, the number of days for expiry gets lesser and lesser. Given this let me ask you this question – With roughly 18 trading days to expiry, traders are willing to pay as much as ₹100/- towards time value, will they do the same if time to expiry was just 5 days? Obviously, they would not right? With lesser time to expiry, traders will pay a much lesser value towards time.
“All other things being equal, an option is a depreciating asset. The option’s premium erodes daily and this is attributable to the passage of time”.
All options – both Calls and Puts lose value as the expiration approaches. The Theta or time decay factor is the rate at which an option loses value as time passes.
Theta is expressed in points lost per day when all other conditions remain the same.
Theta is a friendly Greek to the option seller. Remember the objective of the option seller is to retain the premium. Given that options lose value on a daily basis, the option seller can benefit by retaining the premium to the extent it loses value owing to time.