An Options trader, in order to execute successful and fruitful trades, must keep in mind that analysis is the thumb rule of Options market. None of the strategies go waste if they are chosen rightly for the perfect stock and a suitable investment goal. Let’s learn one concept that provides different parameters to study and measure options. Options Greeks are a way to measure the relative sensitivity of an option’s price to stock prices, market volatility, and timing, namely Delta, Gamma, Theta, Vega, and Rho.
Read our blog “What are Options Greeks?” to understand the use of each Greek alphabet and what are they used for.
In this blog, we will particularly discuss about theta, and how is theta calculated.
It is very helpful in Options trading if you likely know the time window for when a particular option position will close, commonly referred to as “time to expiration.” Theta’s particular role is to focus on time decay. Theta is generally used to gain an idea of how time decay is affecting your option positions. Theta helps you measure how much value an option loses over the course of time. If you’re interested in options, time to expiration is an important factor to consider as you’re building your strategies.
CALCULATION OF THETA (θ)
Theta measures the decline in value (premium) of an option over time as it reaches expiration.
Theta = Change in an option premium / Change in time to expiry.
Usually theta is negative for a long option, whether it is call or put.
Each moment that passes causes some of the option’s time value to “decrease” And not only does the time value decrease, but it does so at a more rapid pace the closer you get to expiration.
Generally, Theta is considered to the enemy of the options buyer while a friend to the options seller. That’s because, as time decays, it becomes cheaper for the seller to buy back the options to close out short positions.
THETA CALCULATION IN RELATION TO OPTION BUYER
An Option buyer is entitled to pay the premium knowing that he carries a limited risk and an unlimited profit potential. The reward is unlimited to the extent till where the market rises. Option Buyer has the potential of earning unlimited rewards.
Nifty spot price is 15000 , And you buy a Nifty 15200 OTM Call option
What is the likelihood of this call option to expire In the Money ( ITM ) ?
In simple words, Given Nifty is at 15000 today, what is likelihood of Nifty moving 200 points over the next 30 days and therefore 15200 CE expiring ITM?
The chance for Nifty to move 200 points over the next 30 days is quite high, hence the likelihood of an option expiring ITM upon expiry is very high
What if there are only 15 days to expiry?
An expectation that Nifty will move 200 points over the next 15 days is reasonable, hence the likelihood of an option expiring ITM upon expiry is high (notice it is not very high, but just high).
What if there are only 5 days to expiry?
Well, 5 days, 200 points, not really sure hence the likelihood of 15200 CE expiring in the money is low
What if there was only 1 day to expiry?
The probability of Nifty to move 200 points in 1 day is quite low, hence I would be reasonably certain that the option will not expire in the money, therefore the chance is ultra-low.
The more time for expiry the higher is the higher are the chances for an option to expire In the Money (ITM)
Theta calculation in relation to Option seller
Option seller sells/writes an option and receives the premium for it. When he sells an option he is very well aware that he carries an unlimited risk and limited reward potential. The reward is limited to the extent of the premium he receives. He gets to keep his reward (premium) fully only if the option expires worthless.
If he is selling an option early in the June month he very clearly knows that by virtue of time, there is a chance for the option he is selling to transition into ITM option, which means he will not get to retain his reward (premium received)
Let’s see this through practically:-
The Intrinsic Value of options
Premium = Time Value + Intrinsic Value
Intrinsic Value is the money you are to receive if you were to exercise your option today. Intrinsic Value is always positive or zero and can never be below zero.
For Call options Intrinsic Value = Spot price - Strike price
For Put options Intrinsic Value = Strike price - Spot price
Let us calculate the intrinsic value for the following options assuming Nifty is at 15000 –
Intrinsic values for the above options are as follows –
15200 CE = 15000 - 15200 = +200
15250 CE = 15000 - 15250 = +250
14800 PE = 14800 - 15000 = -ve value hence 0
14750 PE = 14750 - 15000 = -ve value hence 0
We hope we fed your curiosity related to "What is options theta?". As you see Theta addresses the unavoidable loss in value that options experience as time passes. Of all these risk measures, the time to expiration is the one thing that’s certain. Time keeps marching on, which means that most options prices will continue to “decay,” or lose value over time. So?
Seek help from the strategies and profit from the decay by making it potentially work in your favour.