Options Analysis  |  APR 1996

On Option Theta by Lawrence D. Cavanagh

On Option Theta by Lawrence D. Cavanagh Options traders use various measurements to calculate an option's risk, the calculations of which are denoted by Greek letters. One example is theta, which is the measure of how much an option's price decreases for each day that passes. A nyone who has ever traded options quickly becomes aware that if all things remain equal, then over time, the price (or premium) of the option declines. Theta (q) is the Greek letter used to mark the decay of an option premium over time. This price decay is nonlinear (that is, it changes over time), and most of the time, it accelerates as the expiration date approaches. For an option buyer, theta can indicate the daily cost of holding the option. For an option writer, theta can indicate the daily profit that accrues from being short the option. Understanding the whys and wherefores of theta thus becomes important, and here we explore why option premiums decay the way they do. AT-THE-MONEY THETA An option's total premium consists of its intrinsic value and its time value. Intrinsic value is what the option is worth if exercised immediately. If positive, it is the difference between the price of the underlying tradable (stock, bond or commodity) and the strike price. Time value is the part of option premium that exceeds intrinsic value, based on the probability of the underlying stock going through the strike price and from the profit or loss potential caused by the assumed dispersion of future price outcomes.

by Lawrence D. Cavanagh