The Greeks: A Series - Theta 𝛩
December 23, 2022
Intro
In options trading, Theta is one of the “Greeks” – a set of metrics used to measure the sensitivity of an option’s price to various factors. Theta, specifically, represents the time decay of an option. As options have a limited lifespan and expire at a specific date, Theta measures the rate at which the option’s value decreases as it approaches its expiration date.
Theta is an important metric for options traders to consider, as it can have a significant impact on the profitability of an options trade. For example, if an options trader buys a call option with a high Theta, the option will lose value faster as time passes. This means that the trader will need to either exercise the option or sell it before expiration in order to realize a profit. On the other hand, if an options trader sells a call option with a high Theta, the option will lose value faster, which can be beneficial for the seller as they will receive the premium from the option buyer.
Theta in an example trade
- An options trader buys a call option with a strike price of $50 and a Theta of -0.05. This means that the option will lose $0.05 in value each day as it approaches expiration.
- The options trader buys the option when it is trading at $3.00 and the underlying stock is trading at $55.
- If the stock price remains unchanged, the option will lose value each day due to Theta, even though the stock price is above the strike price.
- If the stock price falls below $50, the option will become worthless at expiration and the trader will lose the entire premium paid for the option.
- If the stock price rises above $50, the option will be in the money and the trader can exercise the option to buy the stock at $50 and sell it at the higher market price, realizing a profit.
In this example, the options trader needs to consider the impact of Theta when deciding whether to hold onto the option or sell it before expiration. If the stock price is not likely to rise above the strike price before expiration, it may be more profitable for the trader to sell the option before it loses all of its value due to Theta.
In summary, Theta is an important factor for options traders to consider as it measures the time decay of an option and can impact the profitability of a trade. By understanding Theta and how it affects the value of an option, traders can make more informed decisions about when to hold onto an option or sell it before expiration.
Personal blog by Alex Virdee, 