The Theta Factor: Master Time Decay for Trading Success

What is Theta?

Theta, often referred to as "time decay," is one of the Greek letters used to quantify the impact of time on the value of an options contract.Theta helps option traders measure how much value an option might lose each day as it approaches the expiry day. To understand Theta better, let's first understand how is the total value of an option determined using the below given example.

Understanding Intrinsic Value & Time Value

Total value of an option = Intrinsic Value + Time Value

Intrinsic value is the portion of an option's price that is directly related to the difference between the current price of the underlying asset and the option's strike price. It represents the immediate value that the option holder would gain if they were to exercise the option immediately.

Time value is the premium that an option buyer is willing to pay for the potential future movement of the underlying asset's price, based on the expectation that favorable price movements may occur before the option's expiration.

Let’s say a stock is trading at Rs 1000 and its Call option with a strike of 950 is priced at Rs 65. Here, the intrinsic value will be Rs. 50 (1000 - 950). So if the option is priced at Rs. 65, the balance Rs. 15 represents the time value of money. Any surplus value beyond the intrinsic value is the time value.

ITM options have relatively higher Instrince Value, OTM options have no Intrinsic value and derive their value entirely from Time Value while ATM options have minimal Intrinsic Value and highest time value.

As the time passes, the OTM options to become ITM keeps on reducing and hence their time value keeps on reducing. Theta helps us understand the decrease in value of options premium as we move closer and closer to expiry.

To Summarise:

Options lose value as we move closer to expiry date of the contract, this is because the uncertainty of the option being ITM or OTM keeps on decreasing as the time passes. Example, chances of a stock moving 10% in a month is much higher than the chances of a stock moving 10% in 1 week.

Interpretations

Options contract with highest theta signifies that, keeping all things the same, this contract will lose most value as we near the date of expiry. As the time to expiry reduces, the price of the option contract also reduces. Eventually on the date of expiry:

• - the option price of ITM is nothing but the Intrinsic Value
• - all OTM options expire worthless at 0 since they have 0 intrinsic value and 0 time value