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THETA definition: How does moneyness affect time decay?

THETA definition: How does moneyness affect time decay?

Time decay, also known as theta, is a concept commonly used in options trading to describe the rate at which the value decreases as it approaches its expiration date. It is one of the essential factors affecting the price of an option and is particularly significant for options that are close to expiring.

As an option gets closer to its expiration date, the time value of the option diminishes because there is less time for the underlying asset’s price to move in a favourable direction. Time decay is generally more pronounced in options with a shorter time to expiration.

Options Time Decay Formula

Here’s how to calculate time decay (theta):

Theta (Time Decay) = (Change in Option Price) / (Change in Time)

However, in practical terms, individual investors do not typically calculate theta themselves. It is usually provided by most financial platforms or brokerage accounts that offer options trading. Theta is expressed as a negative number because it represents the decline in the option’s value over time.

For example, if an option has a theta of -0.03, it means the option’s value is expected to decrease by $0.03 per day (all other factors being equal). Therefore, the option would lose $0.03 in value each day it gets closer to the expiration date.

It’s important to note that time decay is just one of the factors influencing the value of an option. 

Other critical factors include the underlying asset’s price movement (delta), volatility (vega), and interest rates (rho). 

Traders and investors use these factors together to evaluate and make decisions about options trading strategies. 

If you are new to options trading, it’s advisable to seek guidance from an experienced financial advisor or conduct thorough research to understand the risks and complexities involved.

How Time Decay Works

Let’s see how exactly time decay works. Time decay represents the value decrease of options as the expiration date gets closer. 

Time value of an option is the role of time in the creation of the value of an option. The time value will decline as the expiration point approaches since there is less time to gain profit from the option

Investors typically play shorter-term options when there is an event drastically moving the price in the near term.

Time Decay vs. Moneyness

Time Decay and Moneyness are two important concepts in options trading that impact the price and behaviour of options, but they are distinct and serve different purposes. Let’s compare them:

Time Decay (Theta): Time decay, represented by the Greek letter “theta,” refers to the rate at which an option’s value decreases as it gets closer to its expiration date. It is a measure of how much an option’s price is expected to erode over time due to the diminishing time remaining until expiration.

Moneyness: Moneyness describes the relationship between the current price of the underlying and the strike price of the option. It categorizes options into three states: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). An option’s moneyness influences its intrinsic value and can determine whether the option will be exercised at expiration.

Impact on Option Pricing

Time Decay (Theta): Time decay is a negative influence on an option’s price. As the amount of time passes, the time value of an option decreases, causing the option’s premium to decrease. The closer the option is to expiration, the more pronounced the time decay becomes, especially in the last few weeks or days before expiration.

Moneyness: Moneyness affects an option’s intrinsic value. An in-the-money (ITM) option has intrinsic value because it has a positive difference between the underlying asset’s price and the option’s strike price. At-the-money (ATM) options have no intrinsic value, while out-of-the-money options have no intrinsic value and are composed entirely of time value.

Purpose:

Time Decay (Theta): Time decay is a crucial factor for options traders to consider when choosing options strategies. Traders can take advantage of time decay by selling options, especially in stable or declining markets, to profit from the decline in the option’s time value as expiration approaches.

Moneyness: Moneyness helps traders assess an option’s potential profitability and risk. ITM options are more expensive than ATM or OTM options, but they offer the benefit of having intrinsic value and are more likely to be exercised at expiration. Traders can select options based on their risk tolerance and market outlook, depending on whether they want to speculate on price movements (ATM or OTM options) or hedge their positions (ITM options).

Time decay example

Let’s look at a simple example to illustrate time decay (theta) in options contracts trading ie, the passage of time affecting the price:

Suppose you are considering two call options on the same stock, XYZ, which is currently trading at $100 per share, and both options have an expiration date of one month from today. The two call options are as follows:

Option A:

Strike Price: $95

Current Option Price: $7

Option B:

Strike Price: $105

Current Option Price: $3

Now, let’s assume that over the course of the next few days, the stock price of XYZ remains unchanged at $100. All other factors affecting the option prices, such as volatility and interest rates, also remain constant.

After a week, you check the prices of both options:

Option A:

Options Price: $6.50

Option B:

Options Price: $2.50

In this example, both options experienced time decay over the one-week period. Notice that Option A, which was initially priced at $7, has decreased in value to $6.50, while Option B, which was priced at $3, has decreased to $2.50.

This example illustrates how time decay works. As the expiration date gets closer, the price tends to decrease, which is an essential consideration for options traders and investors

They need to be mindful of time decay when implementing various options and strategies to avoid unwanted losses due to eroding time value.

Options with the greatest time value are typically those with a longer time to expiration. The more time an option has until it expires, the higher its time value tends to be. 

Longer-dated options give the holder more opportunities for the underlying asset’s price to move in a favourable direction before the option expires, making them more valuable than options with less time remaining.

Options that typically have higher time value:

LEAPS (Long-Term Equity Anticipation Securities)

 LEAPS are long-term options with expiration dates typically extending up to several years into the future. 

These options can have substantial time value because of the extended time frame, which provides more opportunities for significant price movements in the underlying asset.

Long-Term Options

 Options with expirations that are several months away can also have relatively high time value compared to short-term options.

At-the-Money Options AMO

 Options with strike prices close to the current market price of the underlying asset tend to have higher time value than options that are significantly in-the-money or out-of-the-money. At-the-money options have the most potential for price movement, leading to higher time value.

Options on High-Volatility Stocks

 Options on stocks with high implied volatility often have higher time value. Implied volatility reflects the market’s expectations of future price fluctuations, and higher volatility implies a greater likelihood of significant price swings, leading to increased time value.

Options on Low-Dividend Stocks

For options on stocks that do not pay dividends or pay low dividends, the time value may be relatively higher. Dividends can reduce the time value of call options, as the option holder does not benefit from receiving dividends while holding the option.

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