Big Money, Less Risk by Mark Larson

Author:Mark Larson
Language: eng
Format: mobi, epub
Publisher: Wiley
Published: 2012-09-19T23:00:00+00:00

Theta

Theta shows how much value the option price will lose for every day that passes. An option contract has a finite life, defined by the expiration date. As the option approaches its maturity date, an option contract’s expected value becomes more certain with each day. This time value, also called extrinsic value, represents the uncertainty of an option. Theta is the calculation that shows how much of this time value is eroding as each trading day passes—assuming all other inputs remain unchanged. Because of this negative impact on an option price, the theta will always be a negative number. For example, say an option has a theoretical price of $3.50 and is showing a theta value of −0.20. Tomorrow, if the underlying market opens unchanged (i.e., if it opens at the same price as the previous day’s close), then the theoretical value of the option will now be worth $3.30 ($3.50 − $0.20).

The option graph in Figure 3.3 illustrates the effect on an OTM call option as it approaches maturity date. The increment as each day passes is what the theta calculates. You will notice that in the last remaining days of an option’s life, it loses its value quite rapidly. This is one of the concepts traders use as a reason to short (sell) option contracts; they want to take advantage of this rapid rate of decay in an option’s value as each trading day passes.

Figure 3.3 Option Price as Time Passes

For color charts go to: www.traderslibrary.com/TLECorner • Chart by: thinkorswim.com

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