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After investing in stocks, experienced investors often consider options trading. This refers to agreements where the buyer has the choice to purchase or sell an underlying asset. To mitigate risks in this type of trading, investors can utilise Options Greeks or factors for value assessment. Among all the different factors, this blog will particularly focus on the concept of Theta options. So, let’s get started.
An overview of options greeks
These are mathematical tools used to measure how the value of options contracts changes with different factors. These include the current price of the asset and the level of market volatility. They help you make more informed decisions about options, such as whether to exercise your right to buy or sell the underlying asset.
Options traders can use the five types of factors for various objectives. Take a look at them in this table:
| Option Greek | Purpose |
| Gamma | The underlying asset’s price |
| Delta | The underlying asset’s price |
| Theta | Maturity time |
| Vega | Fluctuations or volatility |
| Rho | Interest rate |
A deep dive into Theta options
Theta options measure how quickly an option loses its value as its expiration date approaches. It indicates the daily decline in the option’s price due to its finite lifespan. Theta assumes that options will inevitably lose value over time. So, they become less appealing to investors as they near maturity.
It is always a negative value, reflecting the reduction in the option’s worth each day. For instance, if Theta is -3, the option’s value will decrease by 3 rupees on that particular day, assuming all other factors remain unchanged.
More about Theta in options
Factors representing the risk associated with the time loss of an option contract can be called Theta decay options. When a contract is created, it has a specified strike price. It refers to the amount at which the investor can exercise the option.
However, the investor can only utilise it if the value reaches the strike price before the contract expires. As the time until expiration decreases, the value of the option decays. It can create the risk of the investor not being able to exercise the option before it loses value.
As options near their expiration date, their profitability tends to decrease. This is because there is less time for them to become profitable or expire in a valuable state.
However, options with a longer expiration date have more time to reach the target price. So they are more attractive and can generate profit potentially.
When comparing two options with the same strike price and underlying asset, the one with a longer expiration time will generally have a higher value. This is known as time decay, and the rate at which an option’s value decreases over time is indicated by Theta.
Interpreting Theta
Theta decay options represent the value lost due to time and price falls. It is always negative for long options (options bought), indicating that their time value decreases as time passes. At expiration, long options have no time value left. This means that their value increases for option sellers (those who write or sell options) and decreases for option buyers (those who purchase options).
Therefore, Theta is a favourable indicator for option sellers (positive Theta trade) because their profit increases as long as the option’s time value decays. Conversely, it is an unfavourable indicator for option buyers (negative Theta trade) because the value of their purchased options decreases over time.
Calculating Theta in options
Theta is a value that can be either negative or positive, depending on the timeframe of the options contract. If you are wondering how to calculate Theta in options, use the following formula:
Theta = – (∂V/∂τ)
Where:
- ∂ is the first derivative
- V is the theoretical value of the option price
- τ is the time remaining until the option expires
Theta is usually measured in terms of the premium or rupees and can be calculated daily or weekly. However, it’s important to note that Theta options values are not exact, as they are based on theoretical assumptions. Theta values assume that volatility and price fluctuations will continue and do not account for significant changes in market conditions that could affect these variables.
Strategies for Theta options trading
Traders often resort to the following strategies for Theta options.
- Short OTM vertical spread
In a short vertical spread, you sell an option near the current stock price and buy it further away from the value. A short call spread involves buying a call option further out of the money and selling a call option closer to the current price. A short put spread involves buying a Theta put option further out of the money and selling a put option closer to the current price.
Vertical spreads indicate the trader’s expectations about the future price movements of the underlying security. A short call spread implies a bearish view, while a short put spread implies a bullish view.
- Iron condor
An iron condor is a combination of two short vertical spreads with different strike prices. Both spreads expire on the same date and have a neutral directional bias. Each vertical spread consists of a short call option and a short put option, with one vertical spread above the current underlying price (OTM) and the other below.
The profit is limited to the first premium received when selling the options. The distance between the strike prices of each vertical spread primarily determines the risk.
- Calendar spread
Calendar spread strategies exploit the tendency for time decay to increase as expiration approaches. In a calendar spread, you sell an option with a short-term expiration date and buy an identical option with a later expiration date. This strategy defines your risk, which is generally capped at the cost of the spread (the premium you pay).
Summing up
Options gradually lose value as their expiration dates approach. Investors aim to comprehend the rate of this decline and estimate the value loss over a given period. Theta specifically measures the daily value loss of an options contract, assuming other factors remain constant. Understanding the concept of Theta options empowers traders to make informed decisions to optimise their trading strategies.
FAQs
Negative Theta in long options indicates that the option’s worth diminishes with time’s passage, assuming other factors remain constant. This decline is known as time decay. An option position with a negative Theta signifies a declining value over time, all other things being equal.
Theta continues to decay during weekends. Options models typically account for weekends, resulting in a decay period of seven days rather than just the five trading days.
In options trading, the Theta value, which is positive for a seller of short-term options, represents the value of time decay. As time passes, the value of the option decreases, which benefits the seller.
Options closest to the current market price have the highest rate of Theta. Options that are deeply out-of-the-money or deeply in-the-money have the lowest Theta. As the expiration date approaches, the Theta decay accelerates for options close to the market price.
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