When it comes to options, the Greek letter theta indicates how much the price of an option will decrease over time. It is also known as the “time-out” of an option.
By reading this article, an investor will have a better understanding of what theta is and how it can be used to improve their options trading skills.
The value of an option is made up of its inner and outer value. The intrinsic value is the difference between the exercise price and the market price of the underlying security when the option is “in the money”. The extrinsic value is made up of the time value and the implied volatility of an option. Theta focuses on the time value and assumes that the implied volatility remains constant.
As the time for an option nears expiry, the external value of that option decreases. Theta is a measure of how much this extrinsic value decreases as the option nears expiry.
Let’s look at a few examples.
- Suppose an investor has a call option with an exercise price of USD 100 for stock ABC. ABC’s market price is $ 93. The investor bought this option for $ 5. The option will expire in five days. For example, suppose the option’s theta value is -1.
- This means that as the expiration date approaches, the value of the option will decrease by USD 1 per day. If four days have passed, the option’s value is now $ 1 (5 – 4 = 1).
- This option has no intrinsic value as it is not “in the money”. Hence its total worth comes from its external worth. Over time, its outward worth decreases. Theta tells us how much it will decrease.
- Suppose an investor has a put option on ABC with an exercise price of $ 95. ABC’s market price is $ 100. This option also has no intrinsic value because it is not “in the money”. Its worth comes only from its external worth. As the option nears its expiration, its outward value diminishes and theta tells us by how much. As the expiration date approaches, the value of the option will decrease by $ 0.50 per day. If six days pass, the option’s value is now $ 7 (10 – 3 = 7).
- For example, let’s say the price of this option is $ 10 and it will expire in ten days. The theta value is -.50.
By understanding theta, an investor can see how much the price of an option will be affected as it nears its expiration date. This is a useful tool when it comes to options trading.