In our last article, we covered the Greek delta, which helps estimate how sensitive your option is to changes in price of the underlying stock. However, there are other variables that determine your option values. We will be looking at theta, or time, another important Greek to take note of when trading options.
Read Also: Finance Dummies Series: Options (Part 3)
What Does Time Have To Do With Trading?
Options are contracts with fixed expiry periods, with the payoffs heavily dependent on what happens to the price by the expiry date. For example, if your stock price trades at $4.90 by expiry, but the call option strike price is $5 – your option is worthless.
In determining the value of financial assets, the concept of probability is heavily relied on. This may seem complicated, but from a common sense perspective – you apply probability in your everyday life perhaps without even knowing it. Take the example of a blackjack game, where you are the dealer. If your friend refuses to draw additional cards, you have to make a decision of whether to open his cards or draw another one. This decision is made off you determining the probability of your current hand being able to beat his.
Similarly, with more time to expiry, chances of your option going in-the-money is higher. More things could happen to the stock price with more time, and the corresponding price move could also be larger as compared to smaller timeframes.
Implications Of Time
The effect of time is measured by the Greek theta, which measures the change in option price in one day resulting from time decay. It can be implied from the previous section that with less time to expiry, the chances of your option going in the money decreases. Thus, every day options will slowly “decay” by the value of “theta”. This is why options closer to expiry are also much cheaper than options that are not.
From the above, we can see that if you buy a call option, it is important to set a timeframe for your investment view to play out. For example, you buy a 1-month option and the price stays in a range for 3 weeks, only going in-the-money at the last minute. The 3 weeks of time decay would most probably eat up the profits from the stock going in-the-money. You need to be right on both timing and direction, which is what makes standard long option plays difficult for most people to make money on.
From this, the maxim “There is no free lunch in this world” is obvious. If you buy options, you need to be extremely precise on timing, direction and magnitude of the move. This comes with the promise of small maximum loss. On the other hand, by selling options, you benefit by allowing time decay to make money for you. However, you are exposed to theoretical unlimited loss.
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