In relation to options, the Greek letter, Theta, represents how much an option’s price will decline due to the passage of time. It is also known as an option’s “time decay.”
By reading this article, an investor will gain a better understanding of what Theta is, and how it can be used to better his options trading skills.
The value of an option is made up of intrinsic plus extrinsic value. Intrinsic value is the difference between the strike price and market price of the underlying security, when the option is “in-the-money.” Extrinsic value is made up of the time value and implied volatility of an option. Theta focuses on time value and assumes implied volatility remains constant.
As time approaches expiration on an option, that option’s extrinsic value decreases. Theta is a measure of how much that extrinsic value is decreasing as the option approaches expiration.
Let’s look at a couple examples.
- Assume an investor owns a call option with a strike price of $100 for stock ABC. ABC’s market price is $93. The investor bought this option for $5. The option expires in five days. Assume the Theta value of the option is -1.
- This means that as the expiration date gets closer, the value of the option will drop by $1 per day. If four days have passed, then the value of the option would now be $1 (5 – 4 = 1).
- This option has no intrinsic value since it is not “in-the-money.” Therefore, all of its value is coming from its extrinsic value. As time passes, its extrinsic value will decrease. Theta tells us by how much it will decrease.
- Assume an investor owns a put option for ABC with a strike price of $95. ABC’s market price is $100. This option also has no intrinsic value since it is not “in-the-money.” Its value is only coming from its extrinsic value. As the option approaches its expiration, its extrinsic value will decrease and Theta will tell us by how much. As the expiration date gets closer, the value of the option decreases by $0.50 per day. If six days pass by, then the value of the option would now be $7 (10 – 3 = 7).
- Assume this option’s price is $10 and it expires in ten days. The Theta value is -.50.
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Understanding Theta will allow an investor to see how much an option’s price will be affected as it approaches its expiration date. This is a useful tool to have when it comes to options trading.