What is Theta (Time Value) in Options Trading?
Without a doubt, theta is the most popular and used Greek in options trading. Every trader is lured by the prospect of eating premium from time decay.
What is the time value in an option contract? Every options contract has two components: Intrinsic value and time value. The time value component is very high at the start of the options contract, but as time elapses, it starts melting. However, the strange thing is the rate of change of decay in theta increases as the date of expiration comes closer.
To understand this point better, take the example of a weekly contract.
- The rate of theta decay from Thursday to Friday will be less than the rate of theta decay from Monday to Tuesday.
- The rate of decay will be less on Tuesday than Wednesday.
- The rate of decay will be less from Wednesday to Thursday.
So, if you want to make a credit spread, it is always advised to choose the dates carefully.
To take advantage of theta decay in weekly options, it is advisable to make a spread on Friday after 3 PM. The advantage is that the time value melts during Saturday and Sunday.
Another option is to make a credit spread on Wednesday after 3 PM as the rate of change of premium will be very high on Thursday.
Applications of Theta decay in options trading
All credit strategies in options are an attempt to benefit from the theta decay. Another thing to understand is In general, options of high volatility stocks have higher theta than low volatility stocks. This is because the time value premium on highly volatile stocks are higher and so they have more to lose per day.
Interpretation of Theta
If you buy an option, time is not your friend as it melts every day. And if you buy an option near expiry, the probability of losing is very high as time decay or theta decay is higher. However, if you’re short an option contract, time is on your side. You will gain a premium even if the stock price does not move.
Key Things to Understands About Theta
In-the-money (ITM) option will always have higher theta than an at-the-money (ATM). ITM options have no extrinsic value, so they have nothing to decay.
Options Theta value is highest for At The Money (ATM) options It goes down ITM and Out Of The Money (OTM) options progressively as they have little to decay.
Why this happens. Theta is affected by moneyness and the length of time left to expiration. The theta value is the highest point when an option is at the money.
As the underlying security moves further away from the strike price as the option goes into money or out of the money, the theta goes down.
Therefore, if you short a far ITM option, you should not expect to earn from time value decay.
Also Read: Understanding Options Greeks: Delta, Theta, Gamma, and Vega
Also Read: What is Implied Volatility?