What is Theta in Options?
The previous posts explain Delta, Gamma and Implied Volatility. Check my main page for more options content.
Theta represents the impact of time on options. Whether it is a call or a put, the theta is usually negative. With each passing day, the price of the option changes by one theta value. In short words, theta reflects the effect of time change on the time value of money, which is usually a negative effect.
The larger the theta value, the greater the effect of time on the option price.
Looking at AMD's call options expiring on November 26, 2021, this option currently has only one trading day left to expiry.
From the figure above, with the current price (at-the-money option) as the center, in the direction of out-of-the-money options and in-the-money options, the corresponding theta is getting smaller. The graphs show the direction of out-of-the-money options and in-the-money options, their time value keeps getting smaller. Therefore, with the same expiration date, the daily decrease in time value will be less, so theta is getting smaller.
The combination of theta and delta helps us to choose options better.
The following theta is discussed in terms of their absolute value (theta is usually negative).
If we want to choose an option to better track changes in the stock, we must make ensure that the delta is greater than theta.
If you buy an option today and the stock changes by $1 the next day,
When delta > theta, then the corresponding option price increases by delta minus theta.
When delta < theta, then even if the stock goes up, the option price will go down because the value of delta is less than theta.
But when we are selling options, we definitely hope to earn the right when it expires, and hope that its time value will continue to decrease.
Therefore, when selling options, try to choose an options contract where delta value is less than theta, so that the price of the option will not reflect the change of the stock price well. As time goes by, the price of the option gradually returns to zero, and we can successfully earn the premium.
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buy option: delta>theta
sell option: delta<theta