To add to our continued series on using Thinkorswim to analyze the option Greeks, we will look at Theta, or the time decay factor.
If you need to refer to the other posts, here they are: Delta and Gamma.
Options Trading: Theta
Theta is an estimate of how much the theoretical value of an option decreases when 1 day passes and there is no change in the underlying stock price or volatility. Theta is used to estimate how much an option’s value decreases as time passes. Long calls and puts always have negative theta, and short calls and short puts have positive theta. The stock itself has zero theta, as its value is not constrained by an expiration date.
Theta doesn’t reduce an option’s value at an even rate. Theta has much more impact as an option nears expiration, since there is less time to realize a move in the underlying stock. Theta is highest for ATM options, and is progressively lower as options are ITM or OTM. The theta of options is also lower when there is less volatility, or more days to expiration.
There is a trade-off between gamma and theta. Options that have the highest gamma also have the highest theta.
In the example below, we take the same SPX Sept10 1090 call from the past examples, and we skip forward in time by 1 trading day. Here was the previous example:
ThinkorSwimSPXSept10
In the example above, theta is -38.59. It has the highest gamma, and as a result, it also has the highest theta. It is the highest because it is barely ITM. If we skip forward 12 hours to the beginning of the next trading day, you can see that the price of the option has not changed (the market hasn’t opened yet), but theta and gamma have both increased.
I hope this illustrates the importance of theta and the time value of options.
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This post was written by...
Robert – who has written 317 posts on The College Investor.
Robert is the founder and editor of The College Investor, a personal finance site dedicated to young adult and college student finances. You can learn more about him here and connect with him on Twitter or Facebook.
