Theta: Useful Option Greek to Know Time to Expiration

Theta is one of the most useful options Greeks measures. It measures the rate at which the value of an option falls as the expiry date approaches. In other words, this option Greek measure evaluates the value or price of options with the passage of time. 

If you want to learn all about Theta in options trading, then you are on the right platform. In this article, we are going to explain this important option Greek measure and how it affects option price. Let’s dive deep to find out. 

Theta in options trading

Theta is an option Greek measure that gauges the fall of an option’s value as the expiration date approaches. The passing of time impacts the values of options contracts and this measure calculates that impact. A higher Theta value means a higher rate of change in the value of an option and vice versa.

Explanation

Time decay in options trading is a very important aspect of options trading. It refers to the natural decline in the value of an option contract as the expiration date approaches. Time decay affects both short-term and long-term option contracts. Furthermore, the rate of time decay varies from one type of option to the other. For instance, it is the highest for at-the-money options and gradually decreases as the option moves in price. Similarly, time decay for short-term options is high because of a near expiration date. AND Theta is the measure that enables option traders to keep an eye on the rate of time decay that causes a fall in the value of an option. 

Now, a very pertinent question arises here and that is “Why does time decay happen and why does it accelerate as the expiration date approaches?” It is quite a simple phenomenon to understand. As you know, when the expiration date is far, there is more time for the volatility to increase or decrease the price of the underlying security. However, when the expiration date draws near, there is little or no time for the volatility to increase or decrease the price of the underlying security. As a result of that, the demand for options significantly declines, and that in turn reduces their value. This is also the reason that causes options to go worthless after the expiration date. 

Why is Theta an important measure in options trading? 

There are certain factors that significantly affect the value of options. Factors like price fluctuation of the underlying security, volatility, time decay, expiration date, etc. affect the value of options. Luckily, you have option Greek measures to measure the sensitivity of options to these factors. There are five option Greeks measures; Delta, Gamma, Theta, Vega, and Rho. So, Theta is among those important measures because it empowers you to measure the rate of time decay. Thus, you can keep an eye on the effects of time day on the value of your options as the expiration date approaches. 

Theta and expiration date

Additionally, Theta is also important because the time decay rate isn’t linear and substantially increases weeks or days before expiration. Thus, it becomes very crucial to keep an eye on time decay and the expiration date. How does it affects the value of different types of options? The short-term options are more prone to the effects of time decay and have a higher Theta value. Conversely, long-term options are less impacted by time decay because buyers have enough time to earn profit. Therefore, long-term options have a smaller Theta value.

Theta and options’ premiums

Theta is also an important measure because of the fact that time decay impacts options’ premiums. As long-term options have smaller Theta, they have higher premiums and vice versa. Simply put, options with an expiry date after one year have very high premiums as compared to options expiring in one month. 

Theta value

As we have already discussed, the rate of time decay or the rate of change in the value of an option contract as the expiration date draws near is denoted by Theta. It has always a negative value because it always causes a decline in the value of an option and increases day by day. For instance, if the Theta value of an option is -0.2, the value of that option continues to decrease by $0.2 only because of time decay. 

The wrap-up

Time decay or theta is an important measure to bear in mind when trading options. It greatly affects the value of your options over time. In fact, time decay can blow off the entire value of your option. Therefore, it is important to keep an eye on Theta and how it impacts the value of your options contracts.