Tuesday, March 17, 2009

Theta

Theta, the eighth letter of the Greek Alphabet, is another commonly used Greek which enables us to quantify time decay.
Theta quantifies an option’s sensitivity to the passage of time. Simply put, theta tells me how much money I make or lose due to the passage of one day. Options are a decaying asset and thus lose value as time passes. This is commonly referred to as time decay. Theta is a negative number when we’re long an option and a positive number when we’re short an option. Another way to look at option trading is that when we buy options (calls or puts) we’re essentially buying time and when we sell options (calls or puts) we’re selling time. Because of this time component, the more time we buy the more expensive the option.
In most option chains theta is listed as a decimal (-.45). At first glance, this may make you assume that the option is only losing $0.45 a day. That would be an incorrect assumption! The majority of option chains list theta on a per share basis. If I were to buy a call option with a Theta of negative .45, I would be losing $0.45 per share per day. Remember, one option contract controls 100 shares, thus a negative theta of 0.45 means that theoretically that one option contract will lose $45.00 per day. OUCH!
Theta gets higher as an option gets closer to expiration. In other words, theta isn’t linear, but exponential. We can look at a time decay curve to illustrate the rapid increase in theta as expiration nears.
This is primarily why we avoid owning an option over the last 30 days of its life. To minimize our loss due to theta, we buy longer term options. To maximize our gain due to theta, we sell shorter term options. This is primarily why the majority of option selling strategies involve selling front month options (Naked puts/calls, credit spreads, Covered Calls, LEAPS Covered Write, etc…). As you can see below in Figure 1.1, the front month option (June) is losing over 7x the amount that the back month option (Oct) is losing. If my goal were to minimize my loss due to time decay, I would buy the October call option. On the other hand, if I were looking to short a call option and wanted to maximize my gain due to time decay I would most definitely sell the June option.
The Jun08 call option has 4 days to expiration and is losing $67 per day. The Jul08 option has 32 days to expiration and is losing $18 per day. The Oct08 call option has 123 days to expiration and is losing $9 a day.

Theta is highest for At-the-Money options and gets lower as you go further Out or In-the-Money. By buying At-the-Money options we’re placing ourselves in a position to lose more money per day than if we were to buy In the Money or Out of the Money options. This is illustrated in Figure 1.2.
The At-the-Money option has a Theta of -.149. If we move three strikes In the Money (160 strike price) theta is -.114 and three strikes Out of the Money (190 strike price) Theta is -.125

Gaining a proper understanding of the Greeks has been quintessential in my own trading and developing a better understanding of them will put you one step closer to mastering options!

6 comments:

Bill Luby said...
This comment has been removed by the author.
Bill Luby said...

Nice job on the blog, Tyler. I think it's time I added you to my blogroll.

Keep up the good work!

Cheers,

-Bill

Tyler said...

Many Thanks Bill. I've throughly enjoyed visiting your blog as well-

Tyler-

AMIT said...

I like your work.

Invitation letter

Tyler said...

Thanks AMIT - feel free to pipe in with comments or questions on subsequent posts.

Tyler-

shyamal day said...

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