Introduction To Theta
‘Theta’ is the next option-greek that we will understand in this chapter.
Theta measures the change in options price per day change in time to expiry. It can also be referred to as the time decay of an option. This means an option loses value as time moves closer to its maturity, considering other variables constant. Theta is generally expressed in negative numbers and can be thought of as the amount by which an option’s value declines every day. If days Theta is -3.87 that signifies that for the next day the options price will decrease by 3.87.
Option premium = Intrinsic value + Time Value
- Theta of an option is always negative.
- Theta of call and put option is same. (if interest rate is not considered into calculation)
- Theta is highest at ATM and decreases as Spot moves away.
When we buy Call option, negative Theta multiplies by positive quantity, hence gives negative portfolio Theta. This signifies that buying call option means short Theta position.
When we sell Call option, negative Theta multiplies by negative quantity, hence gives a positive portfolio Theta. This signifies that selling call option means long Theta position.
When we buy Put option, negative Theta multiplies by positive quantity, hence gives negative portfolio Theta. This signifies that buying put option means short Theta position.
When we sell Put option, negative Theta multiplies by negative quantity, hence gives a positive portfolio Theta. This signifies that selling put option means long Theta position.
Let’s assume the Nifty spot at 16500, a trader buys a Nifty 16800 call option. What is the likelihood of this call option to expire ITM in the next 29 days? The chance of Nifty moving over 300 points in the next 29 days is quite high.
Now if the trader has only 14 days left to expiry? Now the chance of nifty reaching that mark is still reasonable, so the chances of option expiring ITM is still high, although not very high.
Now if I consider 5 days, I would say that chances of nifty reaching 16800 is low.
And when there is 1 day left to expiry, I would say the chances that Nifty will reach 16800 is very low.
So, the more time for expiry the likelihood for the option to expire ITM is higher.
Now, if a trader sells an option, he receives the premium for it. He is well aware that he carries an unlimited risk and limited reward potential (which is limited to the premium he receives). This is also possible only if the option expires worthless or OTM.
Next, in our upcoming sections, we will study the effect of different parameters on Theta.