What is Theta in Options?

Theta is a sensitivity measurement used in assessing derivatives. It measures the value of the derivative in relation to the time left before the expiration date. Theta can be thought of as the rate of decline in the value of an option as time passes.

Nov 26, 2021 01:11 IST India Infoline News Service

Let’s assume you entered the stock market for the first time. The most obvious entry point is to buy stocks, as the process is fairly straightforward. However, as time goes by, if you put more of your capital in stocks, it creates an alarming situation. You see, the stock market is volatile and experiences correction or a downtrend. In a downtrend, almost all the stocks start to decline in price. In such a situation, if you have all of your invested capital in stocks, your investments may lose a chunk of their value.

What should you do? Diversify.

After having invested in stocks, professional investors move towards Options trading. Options, or options contracts, are essentially a type of agreement between two parties, whereby the buyer has the option but not the obligation to buy or sell an underlying asset. Although options trading can prove to be an ideal market for diversification, it is a complex trading process that can result in losses. To ensure your safety during options trading, you can use options greeks.

This blog will detail Options Greeks and one of its factors known as Theta. But first, a little about Options greeks.

What are Options greeks?
Option Greeks are financial measures based on mathematical formulas to calculate the sensitivity of the price of options contracts against factors such as the price of the underlying asset or market volatility. For example, if you have purchased an options contract and want to know if you should exercise the right, you can use Option Greeks to predict if the price will rise or fall. Five options greeks collectively make the term, these are:
  • Delta
  • Gamma
  • Vega
  • Theta
  • Rho
An options trader uses these options greeks to achieve the following objectives:
  • Option Greeks
  • Objectives
  • Delta
  • Price of the underlying asset
  • Gamma
  • Price of the underlying asset
  • Vega
  • Volatility
  • Theta
  • Time to maturity
  • Rho
  • Interest Rate

What is Theta in Options?
Theta options are defined as an options greek that measures the rate at which the option loses its time value as the expiration date draws near. It is the rate of decline in the option price over time. Because it measures the losing value based on time, Theta in options is sometimes also referred to as time decay of an options contract.

The main assumption behind the Theta options is that an options contract will always lose its value and will be less interesting for the investors as it reaches maturity, as long as every other factor is constant. Theta in options is always a negative number as it is subtracted from the rupee value of the options contract on a particular day. For example, If theta is -3 and everything else is constant, the option value for the particular day will erode by 3 points.

Understanding Theta in Options
Theta options are essentially a part of factors known as Greeks that derives the process of options pricing. An options contract sets a predetermined price, called a strike price when the creator initially makes the contract. It means that the investor can exercise the option only if the underlying asset price reaches the contract’s strike price.

This time frame until expiry is what makes up the base of Theta in options. Theta options quantify the risk that investors take on because of the decaying time as investors can only exercise the options contract for a limited period. For a better understanding, consider the below explanation.

It is a common principle that the profitability of an options contract decreases with time. It happens because once an options contract is near its expiration date, it has less time to be profitable or expire in the money and is not worthless. On the other hand, if an options contract still has a long time in expiry, it sees more interest as it has more time to be profitable and reach the underlying asset’s spot price.

When you compare the value of two options contracts with the same strike price and underlying asset, the one which has more days in expiration will always have a higher value. This time decay and how options contract loses value by every passing day is defined by Theta in options.

How to interpret Theta?
As Theta options always represent the fall in value and the risk of time in an options contract, it is always a negative value. Since the Theta value is always negative in the case of long options, there is always a zero time value when the option finally expires. As a result, the value always increases for the sellers of the option contract but decreases simultaneously for the options buyers. This is why Theta in options is considered a good technical factor for the options sellers but not for options buyers, allowing for the act of selling an option being called a positive theta trade and buying an option as negative theta trade.

How to calculate Theta in options?
The Theta value is negative and positive based on the time frame of the options. For example, Theta in options value is negative for long positions and positive for short positions. You can calculate theta value by using the following formula listed below:

Theta = - (∂V/∂τ)

Here,
  • ∂ is the first derivative.
  • V is the options price based on the theoretical value.
  • τ is the option contract’s time to expiration or maturity.

The Theta in options is always represented as the premium or the rupee amount and can be calculated daily or weekly. However, an investor using Theta in options should keep in mind that the values are not exact as the whole process is theoretical. The Theta values work on the assumption that volatility and price movements are ongoing. Hence, the rate of time decay for an options contract can change the next day, making it slightly unreliable.

Final Word
All options contracts, whether a call option or a put option, lose value every day as the expiration date arrives. Investors try to understand the time decay and how much an options contract can lose in value after a specific time frame. Hence, Theta is always expressed as points lost per day even when all the other conditions remain the same. Now that you know what is Theta in options and how to calculate theta in options, you can go ahead and use it to trade options effectively.

Frequently Asked Questions
Q.1: What is the option theta example?
Ans:
Suppose you purchase a call option with a strike price of Rs 500 for Rs 50. The underlying stock is trading at Rs 450, and the expiration date is after five days. If the theta value is Rs 5, it means that the options contract will lose Rs 5 in value every day.

Q.2: Is positive theta good?
Ans:
Yes, if the Theta option is positive, it is a good sign as it means that the contract will make investors money due to the time decay.

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