What is Theta in options trading?
The Theta of an option measures the amount the price of an option decreases each day as the option nears its expiry (if all factors remain constant). It represents price erosion over time, also known as time decay.
- It is the time component of an options contract and is based on a 1-day decrease in an option's value as expiration approaches.
- It indicates the amount of money a contract is going to lose on a per-day basis, until expiry.
- It is a negative value and gradually increases every day- The probability of an option being profitable or in the money decreases as expiry approaches. This is because time decay tends to accelerate as an option approaches expiry since there is less time left to earn profit from the trade.
- Hence, it is said to be the enemy of option buyers and the best friend of option sellers.
- It is not linear:
- Price erosion of at the money, in the money, and slightly out of the money contracts generally increases as expiration approaches.
- Price erosion of far out of the money contracts generally decreases as expiration approaches.
- Theta affects options contracts differently:
- At the money and out of the money options have a greater theta value and tend to lose money than in the money options.
- In the money options mostly comprise intrinsic value and hence theta is not much of a pricing component. On the other hand, out of the money options have no intrinsic value and are largely comprised of theta.
- At the money options have maximum time value in their premium. As a result, they tend to incur more significant losses over time in comparison to in the money and out of the money options with the same expiry.
- Theta of out of the money options is lower than that of at the money options since the time value is relatively less. However, losses may be greater for out of the money options (due to a smaller time value).
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