Understanding Greeks – Theta

Theta is one of the more important Greeks when trading short-term options.  It is the daily decay that occurs in the option.  In other words, it is the change in the value of the option for the passage of 1 day.  Many people look at options in terms of absolute cash outlay, but fail to recognize that the real concern for a day without price movement is Theta, not total price paid.  When you trade options that are near expiration, Theta is very important.  Long dated options are more focused on Vega, which we discussed earlier (Understanding Greeks – Vega).

As mentioned, the shorter the amount of time to expiration, the higher the Theta of an option.  This is because your option has less time to work, so the option is more likely to converge on intrinsic value.  Let’s dive into intrinsic and extrinsic value here, as that’s really what we are discussing with Theta.

Intrinsic value is how far in-the-money the option is.  The extrinsic value is the rest (assuming no interest and dividend, which is a portion of the value, but we’ll simplify for this exercise).  If the $50 call is trading for $5 with the underlying trading $52, then the intrinsic value is $2 and the extrinsic value is $3.

Because of the way these options work, we know that shorter duration options are worth less than longer duration options.  So as time passes, that $50 call will converge on the intrinsic value – if the option were to expire in 30 seconds, you are unlikely to spend any more than intrinsic value to have that option as it will immediately be converted into an underlying position.

When we look at the performance of a put or call (see my prior posts here and here), you can see that if we stay in a tight range, the option’s time decay will cost us money relative to an equity position.  This is the trade-off for leverage and defined risk – we have a defined amount of time for that option’s benefits to pay off.

The nuance of Theta is the real key.  Which options decay faster?  At-the-money or out-of-the-money?  When does Theta accelerate the most and justify really focusing on that risk over others?  We will discuss these topics and more in greater detail later, but this intro to Theta will hopefully give you a sense of what it does and why it matters.

 

 

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