What is options theta?
The importance of options Greeks is hard to assess. But, according to most options traders, you get hooked once you start looking at them because they convey a tremendous amount of information about the price of an option. The most important ones are the delta and theta. Delta talks about the change in the price of an option, i.e., premium with the change in stock price, while theta tells how an option will be priced with time. Theta deals with the time decay of options.
Negative theta means the price of an option decreases with time and vice versa. For example, if an option’s theta is -0.20, that option’s price will fall $0.20/day. The price of the option will fall by $0.40 in two days and so on. Theta is always negative for an option buyer because the price of an option decreases as the stock price approaches the expiry date. The only way a buyer can gain is if the stock price surpasses the strike price. However, a seller can experience a positive theta as he can first sell an option and buy it at a lower price.
How is it calculated?
Theta or options Greeks as a whole are not just limited to derivatives (options in particular). The concept of Greeks has been there for ages, and they are extensively used in other finance areas. Black Scholes model is used to calculate all the option Greeks, including theta. However, according to the definition, theta can also be calculated by merely deriving an option’s value concerning time.
V = value of the option (intrinsic + extrinsic)
t = time to expiry
How to use theta?
A seller can always get a positive theta, so he can keep selling OTM (out the money) calls. But a buyer is at a disadvantage as the theta is always negative. A buyer can minimize his risk by buying an ATM (at the money contracts) or at prices very near the expiry. He will also gain if the stock price surpasses the strike, also known as the intrinsic value of a stock. There are few strategies based on this concept, most significant being calendar spread, Iron Condor, and vertical spreads.
Volatility will play a significant role in defining the profitability of a particular contract. With minimal risk in the form of premium, options can be considered very lucrative when volatility is irrespective of which side the stock moves.
MarketXLS is an ad-on that can be embedded into MS excel to analyze stocks based on fundamentals. The package also includes option chains with all the information a standard chain provides. But the edge marketXLS has over its peers because the data can be directly imported into MS Excel, which is the most robust software for data analysis. Below is an option chain of MSFT (Microsoft Corporation). I have highlighted the column for theta for the expiry of 19 Feb 2021.
You can check when the theta is minimum and buy contracts accordingly. That way, you can minimize risk. There is also a column for implied volatility, which you can use to maximize profits.
In a nutshell, the concept is similar to the time value of money. Like, the value of money diminishes with time, the value of options also decreases when it gets nearer to the expiry date. Options theta works in favor of a seller and against a buyer. A buyer cannot take advantage of theta, however, he can minimize risk by buying ATM and maximize profits with the help of volatility.
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Learn more about theta calculation here.
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