Theta in Options Trading
Option Greeks are the measures of the rate of the change of the option pricing valuation. Theta is the one factor that can be influencing option pricing. Theta is also known as the Time decay factor. It is denoted by the Greek symbol” Θ “. Theta impacts the rate change of the option premium price decrease in both calls and puts premium when it reaches near to the expiry or maturity date of the option.
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Option Theta and Option Moneyness:
The Theta value is different in call and put options having the same strike price and maturity date.
- AT THE MONEY(ATM): Theta value is the highest value At the money options.
- IN THE MONEY(ITM): Lowest theta value in the ITM options.
- OUT OF THE MONEY(OTM): Lower the extrinsic values near to the time decay.
Positive and Negative Theta value:
Positive theta value is good for the option writers. Positive theta gives incomes(profits) to options sellers. while short the option the daily time decay gives profits s the option writers. The short call and short put of the option sellers get positive theta by shorting the positions.
Theta in Options Trading is against the option buyers it gives a negative theta value. The long position of the call and put have negative theta value will affect the buyers because of the time decay. while we need to eliminate the negative theta, we have to hedge the long positions against the short position, for hedging, we can choose some strategies are Long vertical spreads, Calender spreads, and diagonal spreads.
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How is Theta Calculated:
Theta is calculated as:
- ∂ – the first derivative
- V – the option’s price (theoretical value)
- τ – the option’s time to maturity.
Under the Black-Scholes model, the calculation of theta given by:
- S – the stock price
- K – the strike price
- r – the risk-free rate
- q – the annual dividend yield
- τ – time until expiration
- σ – the volatility
Example of Theta:
Consider a trader can buy monthly expiry nifty call option at a strike price of 14000ce @premium of 300rs. The Theta value of the strike price is -5rs, if a trader can buy a long position on the premium can decline daily by -5rs. The option buyer loses the money because of theta value. If the option writer can short a position can get profits on the time decay of the option premium of the theta value @-5rs on daily basis. On the expiration day, there is no value of the option.
Theta is helpful for the options sellers. It is always against the option buyers. For long naked positions, we can hedge the option strategies against the short positions to reduce the time decay of the theta value increase in a positive sign of the theta.
Author: John Earla
About Author: Currently pursuing Financial Risk Management from GARP(US) and completed Graduation in B.Com computers. John is interested in finance and Risk Analysis.