Theta Decay

Key Highlights

• Theta Decay describes the loss in value of an options contract over time, other factors being equal.

• Theta enables option traders to know how much value an option can lose per day because of the passing of time.

What is Theta Decay?

Theta Decay describes the loss in value of an options contract over time, other factors being equal. It's a time decay measure - the closer an option is to expiring, the quicker it loses value.

Purpose

Theta enables option traders to know how much value an option can lose per day because of the passing of time. It's imperative for:

• Options pricing and strategy

• Risk and expectation management

• Planning entry and exit points in trades

How it Works?

• All options have an expiry date.

• As this date approaches, the time value of the option decreases.

• Theta measures this decrease, usually as a negative number.

Example

If an option has a Theta of -0.05, it will decrease by ₹5 per day (in Indian markets, each option contract usually represents 100 shares) just because time is passing.

Importance in Trading

• Option buyers are damaged by theta decay, particularly when the price does not move their way soon.

• Option sellers (writers) profit from theta since the value of the options they sold loses value with time - perhaps enabling them to repurchase them at a lower price or allow them to expire worthless.

When Theta Decay Picks Up

• Time decay is gradual initially, but picks up in the final 30 days leading up to expiry.

• At-the-money options depreciate most quickly, but deep in- or out-of-the-money options are less susceptible.

Pros & Cons

For Option Buyers:

• Time is not your friend - you need a timely move in your favor.

For Option Sellers:

• Time works in your favor - the longer nothing happens, the more you gain.