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Chapter 3

Theta

As they say,

                        Time is Ticking Away!

We are aware that options as financial instruments are speculative instruments and not investment vehicles. They have an expiry date and are inexistent, post that.

The value of an option can be analysed into two parts (as discussed earlier):

the intrinsic value

and

the time value.

The intrinsic value is the amount of money you would gain if you exercised the option immediately, so a call with strike Rs 50 on a stock with price Rs 60 would have intrinsic value of Rs 10, whereas the corresponding put would have zero intrinsic value.

The time value is the value of having the leisure or opportunity of waiting longer before deciding to exercise. Hence its necessary to understand theta in options trading to have effective option trading strategies.

An extreme deep OTM option on Nifty (call or put) may quote a really low value (non – zero), few days before expiry as there exists an iota of chance that Nifty might touch that strike price (assuming, if a really large price swing were to occur in the remnant time period). Once the option heads to maturity or is just about to expiry, the time left for the option is inexistent and therefore the time value in the option reduces to zero and the option premium is only the intrinsic value of the option, which we all are aware that for OTM options is 0 (zero).

Thus, if you are long an option your portfolio theta is negative: your portfolio will lose value with the passage of time (all other factors held constant).

Options’ Theta measures the sensitivity of the value of the derivative to the passage of time or time decay. Option Greek, Theta, represents the sensitivity of the option's value to changes in time. A first order Greek, which is negative, means that the option's value will decrease as time passes, while a positive theta means that the option's portfolio will increase as time passes. Option Theta decay refers to the natural decrease in the value of an option as time passes and the option approaches expiration, assuming all other factors remain constant.

Theta is almost always negative for long calls and puts, and positive for short (or written) calls and puts.

Portfolio Theta

The total theta for a portfolio of options can be determined by summing the option thetas for each individual position. Consider an example of one such basket of options for stock market in India:

Adjustment of Option trading Strategy for reduce Theta Decay impact, using Quantsapp Option Architect.

The above example is of an ATM stock option, ACC 1820 CE of expiry 23-Feb-23  and sell position of OTM stock option, ACC 1900 CE of similar expiry. The theta of the two options is -73.17, as indicated in the screenshot; which is the summation of individual options’ theta.

 Impact of time on Theta 

Theta, which represents the rate of decay of an option's value, increases as the days to expiration (DTE) decreases. This is because options have a limited lifespan, and as DTE decreases, the option's ability to generate profit decreases, causing its value to decrease faster.

The magnitude of option theta increase will depend on various factors such as the volatility of the underlying asset, the strike price of the option, and the option's intrinsic value.

 

A deep-in-the-money option will have a lower theta compared to an at-the-money or out-of-the-money option because the former has more intrinsic value. Also, the value of theta tends to be maximum at ATM options.

The fall in premium due to time value is not a constant figure over DTE.

The rise in options theta decay as the option heads close to expiry is an important characteristic to note, for traders who buy options, as a sense of caution.

 

As time progresses, time value of option drops, hence theta is expressed as a negative value to signify the decay.

The chart below shows how Theta impacts the option premium, as Expiry date nears. Theta or 1 day drop in premium was -2.5 at the beginning of the chart and went to -18 (7x) in a matter of just 2 weeks. This chart illustrates the behaviour of the value of theta. 

Option Greek Theta Plot with DTE

Hence, some Nifty option traders have a preference for intraday trading, to prevent themselves from the brunt or curse of theta.

Impact of Volatility on Theta

Higher volatility leads to higher option premium! (we are aware of it) therefore implies a higher theta, as options with a greater likelihood of experiencing large price changes are typically more expensive and have a faster rate of time decay. On the other hand, lower volatility results in a lower theta, as options with a lower likelihood of experiencing large price changes are typically cheaper and have a slower rate of time decay.

FAQs

What is Option Theta Decay in Options? 

Theta, is the first order option Greek which measures the sensitivity of option premium to time and time ticks away, implying the option premium over and above intrinsic value prevailing at that juncture, decays or erodes. Theta decay measures the decrease in value of an option due to passage of time while keeping other influencing factors constant.

Why is Theta Negative in Options?

Theta is negative for options due to inherent nature of options and as time passes and approaches close to expiry date of the option, the likelihood of an OTM option to become ITM seems limited and hence the option moves towards the trajectory of being worthless, or time value collapses, as OTM option anyways has no intrinsic value. This collapse in time value is referred to as option theta decay. This characteristic is exploited effectively in expiry day trading.

Can Option Theta be Positive?

Theta of an option will be negative for the option buyer, while option seller benefits from theta. So, option sellers have theta decay in their favour. A positive theta means that the value of the option is decreasing each day, which decreases the portfolio value of the options sold by the trader, helping to generate profits. Option sellers who sell options with high theta values can potentially profit from time decay, as long as the underlying security does not exhibit a price jump (eitherways).

Is High or Low Theta Better

It depends on the trading strategy adopted by option trader and market forecast.

For option sellers, high theta is generally considered appropriate and better as it means the value of the option is decreasing quickly, which decreases the portfolio value of the option sold by the trader, tending to benefit the option seller.

While option buyers, low theta is generally considered better as it means the value of the option is eroding or declining slowly, giving the option holder more time to realize profits from the option. Option buyers who purchase options with low theta values have more time to wait for the underlying security to move in the direction they expect, before the option's value declines significantly due to time decay.

What does Theta 1.26 Mean in Option Trading? 

Theta value of 1.26 in options trading means that the option is expected to lose approximately Rs 1.26 in value per day as the expiration date approaches, from the option buyer’s perspective.

The theta value is expressed as a decimal and represents the rate at which the option's value decreases as time passes. The theta value is a crucial metric in options trading as it helps traders to understand the impact of time decay on the option's value.