Theta of all Times

Theta of all Times

What do you means by Theta & how is it connected with stock trading

If you an option to borrow my pen, whenever you want for the next five years, that is a more valuable option than it would ideally be than having the option available only for a month. Similarly, with financial options, the longer the tenure before expiry, the more valuable that option is. However, there is a flip side to it – with each passing day, the option’s value tends to decrease. This concept is generally termed as time decay and is measured via theta.

Theta

Option theta tells us as to how much the value of an option would change as the time to expiry comes closer. If an option is worth 1.50 dollar with a theta value of .05, the implication is that the option will lose 5 cents by the next 24 hours, everything else being constant. Hence, if the spot price doesn’t move and the implied volatility remains constant, we would see a value of 1.45 dollar the following day.

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The option theta is additive in nature, regardless of the spot price, strike price and their expiration date. It means that the theta from each option in the portfolio can be added or subtracted to provide a total portfolio theta value. If you own an option, it implies that you would be paying a theta bill i.e. your portfolio will be worth lesser tomorrow as compared to today, everything else being constant. On the other hand, if you write short options, you would need to collect theta. As the expiry date comes closer, you would be making profits from being short options, everything else being constant.

So, as a trader, you might ask as to why long options? Instead, you could only short options and gather the time decay from the buyer of the option. However, as easy as it might sound, the reason behind longing is that you own gamma with it. It is quite possible to profit out of longing gamma by gamma trading and gamma hedging. When you are short on gamma, hedging of gamma only loses money and can never earn money. That is the implied trade off for longing and shorting of gamma. By owning gamma, you would pay theta bill but you can earn by being a gamma scalper. However, by shorting options, you would collect theta, but may lose money through negative gamma hedges.

So, it is asymmetrical in nature with regards to the potential payoff being bring short theta versus short of long gamma.

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