Quite a week. State of the Union, Valentine’s Day, Fat Tuesday, female golfer gets bitten by a spider and uses a tee to clean out the venom, my teenage son actually showered without a major battle. Lots to keep our attention diverted. So I just want to remind everyone markets will be closed this Monday, February 18 in observance of Presidents Day. Relax. Take a nap if you are off. You earned it.
Over the last few weeks we have been going over some of the basics of options theory and most recently been talking the greeks. Today we will pick things up with every option sellers favorite – theta. As we discussed earlier, options are a wasting asset. That means they have a finite life span. As time goes on the extrinsic or time value of the option erodes until at expiration day all options will trade at parity.
Theta measures the rate the options decay in one day. For example, if an option has a theta of -3.97, that means the overall value of the option will erode by $3.97 today. Theta can be represented in terms of dollars or decimals, depending on if you are basing it on the actual dollar cost of the options or quoted price.
Factors affecting theta are the same as ones affecting gamma. For at the money options, the passage of time increases theta. Front month at the money options have the greatest theta of any option traded. As we go further out in time, theta decreases however in any given month the at the money option still has the most theta. For the option seller, theta is our friend. We collect the time decay and it becomes an important part of our trading strategy and profit profile. For the option buyer, theta is the enemy as the option he is long is eroding. The option buyer wants movement in the underlying to offset theta while the seller wants markets to stay still so they can collect theta. The effect of movement in the underlying (gamma) and theta are two sides of the same coin. For the option seller, theta is the reward and gamma is the risk. For the option buyer, just the opposite – theta is the risk and gamma is the reward. It is a good idea to keep these in mind as you think about your strategies. Next week – vega.