An option’s contract value is always a combination of instinct and extinct value. Both of these components have their valuation calculations.
The first component of the option’s price, i.e., intrinsic value, refers to the contract’s moneyness (this term is used to describe whether the contract is in the money, out of the money, or at the money). A contract’s value is greater if it is closer to being in the money or is in the money.
Similarly, extrinsic value is related to interest rates, volatility, time value, and dividends. Calculating simple moneyness for intrinsic value is easy. But extrinsic value is a bit more complex. One generally focuses on intrinsic value, volatility, and time value in options trading.
What is Theta?
Theta is a term used to define the time value decline of an options contract. It is known to be a sensitive measurement that helps assess derivatives. A trader can use Thera to calculate the value of the derivative with respect to the time before the expiration date.
Theta options are a part of options Greek known to calculate the rate at which an option loses its time value. Theta is used to know the losing value of an option based on time; it is also called the time decay of an options contract.
The prime assumption in Theta is that over time, the option loses value. As a result, traders would not find it interesting. A point to remember is that Theta is a negative number. At the time of expiration, it will always have zero time value. It happens because time moves only in one direction, and it runs out when an option expires.
Understanding Expiration Date in Theta Options
Theta option is a part of a factor called Greeks. The options contract sets a predetermined price when the creator makes initial contact, called the strike price. So, investors can exercise the option when the asset’s price is similar to the contract’s strike price.
The base of Theta options is the time frame until expiry. Theta options can measure investors’ risk that happens due to time decay. Investors are able to exercise options contracts for a certain time.
Ideally, the contract’s profitability decreases with time. It happens because when an options contract has reached near expiration time, it has less time to expire in the money, and it becomes less profitable.
But if there’s a situation where the options contract has time for expiration, it has more time to become profitable. Thus, traders can exercise such options contracts as they can reach the underlying asset’s spot price.
Suppose two options contracts have similar underlying assets and strike prices. In such a case, you must choose the options contract that has time for expiration as it has a higher value. Theta in options defines how options contracts lose their value and time decay.
Since options are available for trading for a certain period, the measure of Theta is used for quantifying the risk that time has on options buyers. This phenomenon is termed time decay.
Sometimes, there are situations where two options are similar, but their expiration date is different. As a trader, you need to choose an option with a longer expiration date since there is a better chance for the option to move beyond the strike price.
Theta is always represented in negative figures as it is used to know the loss of value of an option and the risk of time. As time passes, the option’s value decreases until it reaches the expiration date. For long options, the Theta is negative. Therefore, there remains zero time value when the option expires.
The option’s value decreases from the buyer’s side, but it increases for the seller. That means Theta is helpful for sellers, but it’s not good for buyers. For this reason, selling an option is called positive Theta trade. So, when the Theta increases, the chances of a seller’s better earning also increase.
Important Things to Consider in Intrinsic Value
The time decay can cause an option to lose its extrinsic value near expiration if all else remains equal. So, long-term holders (buyers) of the option must worry about Theta as it is one of the main Greeks.
But the sellers of options can gain profit from this time decay. It happens because, over time, when an option reaches the expiration date, its value decreases. Thus, it becomes cheaper for the sellers to buy back the options in order to close the short position.
If applicable, options value is made of intrinsic and extrinsic value. During expiration, 0nly intrinsic value remains as time plays a major role in the extrinsic value.
Theta vs. Other Greeks in Underlying Stock
The Greeks calculate the sensitivity of options prices with respect to the variables. For example, the Delta of the Greeks is used for knowing the option’s sensitivity with respect to a $1 change in the underlying stock. Similarly, the Gamma tells the sensitivity of the option’s Delta with respect to a $1 change in the underlying stock. Lastly, Vega is used for knowing how the option’s price changes theoretically for each percentage point.
How to Interpret Theta
As Theta tells the risk of time and decrease of option’s value, it is always a negative value. In the case of long options, the value of Theta is always negative.
For this reason, the value of options contracts increases for the sellers but decreases for the buyers. Hence, Theta is known to be an excellent technical factor only for options sellers. It allows the act of options selling, called a positive Theta, and buying as negative Theta.
How To Calculate Theta In Options
Theta shows a decrease in the option’s price in a day and is always denoted in dollars. So, if there is a Theta value of -0.02, you can conclude that the option has lost $0.02, which is $2 per day. Since the premium linked to the time decreases, Theta is represented in negative terms.
As the smaller Theta value is non-constant, it goes away from expiration. It accelerates the closer it gets to expiration. It’s important to remember that Theta is an advantage for sellers, and it’s not helpful to buyers.
Depending on the time frame of the options, the value of Theta can be negative or positive. Theta is positive for short positions and negative for long positions in options value. Here’s how you can calculate the Theta value.
Theta = – (∂V/∂τ)
- ∂ is the first derivative
- V is the options price based on the theoretical value
- τ is the option contract’s time to expiration or maturity
Ideally, Theta is denoted as premium, and you can calculate it weekly or daily. Since the process is theoretical, an investor must remember that these values are not exact. Based on the assumptions of ongoing price movement and volatility, the Theta value works. For this reason, the rate of time decay can change the next day, which makes it a little unreliable.
How Does Theta Behave?
The options contract decreases as the expiration gets closer. Before the option expires, its time value is at least 0. If an options contract has a long time for expiration, there will be a better opportunity for the underlying security’s price to move. This way, its intrinsic value will increase, leaving the contract with more time value. In short, price movement happens when there is more time.
The decrease in the options value contract around expiration is called time decay, Theta burn, or Theta decay. It’s important to bear in mind that time delay is non-linear. So, as the options contract approaches expiration, its rate of change increases.
If there’s a situation where an option’s time value decreases as expiration approaches, its implied volatility increases. Options lose their time value daily as they are decaying assets.
How Does Moneyness Impact Theta Decay?
If the option is at the money (~0.50 delta), the Theta goes up at an accelerating rate as the time until expiration decreases.
If the option is out of the money (~0.30 delta), Theta increases until expiration decreases. However, this change is less than the money options.
Lastly, if options are out of the money (~0.15 delta), Theta decay happens in a linear manner. Here, the change rate is the largest in the expiration cycle.
Why Theta Matters to Options Traders
As an option buyer, you need to know that Delta is related to Theta. You must also keep an eye on the movement time and direction of the underlying asset because it matters.
If you buy options near the money and closer to expiration, it will bring a rapid Theta to burn. Across strikes and maturities, the time value decay varies.
You must see Theta as one piece of the puzzle as it is one of the parts of options Greeks. While at the money, options have the most Theta decay, but such options are also known to have maximum Gamma and Vega.
What are Theta Gang Strategies?
Theta gang strategies can be seen as game plans that can help you capitalize on time decay. As you know, time decay is an underlying principle that helps know whether or not all other variables are constant. When the time moves closer to maturity, an option loses its value.
Why Should You Use Theta-Based Strategies?
You can use endless schemes and strategies to trade options. Every strategy and scheme has advantages and downsides. Most of the Theta-based strategies are known to have limited return potential. Traders must use Theta-based strategies as they reduce risk and are simple.
Instead of making you predict the movement of stock, the Theta gang is known for simply playing the time game. By focusing on the selling points, traders can collect profit from premiums.
Traders using Theta strategies always use time as leverage. In addition, they chiefly rely on premiums to earn money. You can win a huge profit if you correctly understand and use Theta strategies.
Implementing Theta Gang Strategies
This section has listed two of the best Theta gang strategies. You can understand how these gang strategies operate and how they can minimize the risk so you can get a better return.
Bull Put Spread & Bear Call Spread
The two simple Theta-based strategies are Bull Put Spread and Bear Call Spread. These strategies are also called Put Credit Spread and Call Credit Spread.
You can do credit spreads if you want to sell options without involving the risk of losses. Doing these strategies is simple. All you have to do is:
Step 1: Sell a naked option.
Step 2: Buy a cheaper one.
You need to start selling a naked put to set up a Put Credit Spread. After that, you can limit your potential downside by buying a cheaper Put. You can do a similar thing for Call Credit Spreads, i.e., buying the cheaper Call and selling naked Call.
The difference between the received premium for selling options and paid premium for buying a cheap one is your maximum profit in the Put Credit Spread. While the maximum returns are not impressive, you benefit from reduced risk. A similar thing happens with Call Credit Spread as well.
The Wheel Strategy in Strike Price
The Wheel strategy is the most popular among the available Theta gang strategies. This strategy helps build a regular income by steam by leveraging covered calls and cash covered puts.
You can keep the premium as profit if the Put expires as worthless. By following this similar pattern, you can keep on collecting more premiums.
But if a different situation occurs where Put gets assigned, you are supposed to buy shares at the designated strike price. You sell covered calls at this stage to collect more premium.
Similarly, if a covered Call expires worthless, you can keep the shares and collect more premiums. This cycle goes till Call gets assigned. At this point, you get your money for another round of wheel.
If you want to hold the assigned shares, you can skip selling the covered Call. You can simply spin a new wheel. The main point of the Wheel Strategy is to maintain a steady income through paid premiums.
If you properly implement the Theta-based strategy, you can make frequent returns. It also helps in eliminating the risky trading side. While it requires practice and time, the results aren’t difficult to see.