The Importance of Time Value in Options Trading

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The Importance of Time Value in Options Trading

Summary What Is Theta Options generally lose value with passing time. This process is known as time decay. Theta measures the speed of time decay — how much option premium will decrease in one day.

It means the option premium will decrease by 0. Now it has 55 days left to expiration and theta of Theta Values Options generally have negative theta — electronic money how to earn value with passing time.

There options 100 per minute some rare exceptions, but for now it is safe to take it as a universal rule. Short option positions have positive theta and benefit from time decay unless other factors like underlying price or volatility move against them.

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In general, at the money options have greatest most negative theta, as they have more time value to decay than out of the money or in the money options. Moneyness the relationship between underlying price and strike price is only one of several factors affecting theta. Like all the other Greekstheta can also change with changing volatility, interest rates, or passing time.

Positive or Negative Sign?

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There is some inconsistency in expressing theta among market practitioners and resources. Some write it with positive sign theta of 0. We stick to the latter approach in this tutorial and website. There are good logical options 100 per minute for either approach. The positive sign format fits better with option model mathematics, where theta is the derivative of option premium with respect to time to expiration.

When time to expiration increases going back in timeoption premium increases, and therefore the derivative must be positive.

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In practical use, traders are rarely interested in what will happen to their position yesterday — they are more concerned about the future. Negative sign is more consistent with the way traders normally read and work with theta, as well as the other Greeks — a negative number means the position will lose money. For example, theta increases from Similarly, we say that theta of While all this attention to signs and wording may seem overly meticulous when talking about a single option, it becomes more important with more complex portfolios composed of both long and short options, when the direction of the aggregate exposure may not be immediately clear.

While theta is most commonly expressed as dollars per calendar day, some traders prefer trading days. Those with very long time horizon may measure theta in weeks, while short term traders or those working with options very close to expiration may measure theta in hours or shorter intervals. Calendar or Trading Days? Markets are closed on weekends and holidays.

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As a result, the number of trading days per year is much smaller on average in the US than the number options 100 per minute calendar days After they calculate theta, they convert it to days by dividing by the number of days per year. Dividing by or obviously leads to very different results. While numerous academic papers have been written on which approach is more accurate most tend to side with calendar daysneither is incorrect and neither is perfect — we must keep in mind that any model is just a simplified picture of reality.

It is OK to use either calendar days or trading days.

Time Decay

The only requirement is consistency and knowing what exactly your theta figures mean. When using calendar days, theta means how much the option or portfolio value will change in one calendar day.

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When using trading days, it is per one trading day. Even when all the other factors underlying price, volatility, interest rates stay the same, theta changes as an option gets closer to expiration. Theta of options which are near or at the money tends to increase in absolute terms with passing time.

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When there are still several months left before expiration, the rate of time decay is relatively slow, and it accelerates as expiration approaches. At the money options have greatest theta in the final days before expiration. Options which are further out of the money or deeper in the money tend to lose most of their time value earlier. With long time left to expiration, their theta may real earnings on the Internet on autopilot increase with passing time.

However, as their remaining time gets closer to zero, theta starts to decrease, until both time value and theta get to almost zero. This can happen several weeks before expiration the further from at the money the option is, the earlier this happens. In the final days, far out of the money and deep in the money options have virtually no time value left and no theta.

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Note that although out of the money and in the money options lose a bigger part of their relatively small time value earlier, at the money options always have higher theta — even with more time left to expiration, because their time value is much bigger to start with.

How Theta Changes with Volatility The effect of volatility on theta is simple: Higher volatility means more time value and higher theta, other things being equal. It is important to understand that mere passage of time can never, on its own, generate returns higher than the risk-free interest rate. Indeed, some of them have shown very good risk-adjusted performance in a wide range of underlying markets in the long run.

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However, the source of their profits is not passage of time itself; it is passage of time combined with mispriced volatility. Options on many underlyings tend to trade at inflated prices, higher than what actual realized volatility would justify.

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This is called volatility risk premium. An iron condor is not a good trade just because it has positive theta. It is a good trade if and only if you can make it at a good price, or in other words, if the positive theta is large enough to compensate you for the risk of negative gamma.

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Being able to make such decision requires experience and good understanding of volatility, option prices and Greeks. Theta and Gamma Relationship You can options 100 per minute of theta time decay as the other side of gamma optionality.

These two Greeks represent the cost and benefit of options.

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Long option positions generally have negative theta and positive gamma you pay for buying optionality. Short option positions have positive theta and negative gamma you get paid for providing optionality. Positive theta is good: you make money with passing time.

Negative theta is bad.

Note: Intrinsic value arises when an option gets in the money.

Positive gamma is good: if the underlying price moves in your favor, your profits accelerate ; if it moves against you, your losses slow down. Negative gamma is bad: accelerating losses and decelerating profits. An ideal position would have positive gamma and positive theta.

Unfortunately, there is no such option strategy. Every strategy has strengths and weaknesses. It can position you favorably to either market moves or passage of time — but not both, as one pays for the other.

Option theta and gamma provide quick information on where you are in this tradeoff. How to Calculate Theta Mathematically, theta is the derivative of option premium with respect to time to expiration multiplied by -1 when using the negative sign as we do here. This tutorial focuses mainly on the logic and practical use of theta. All options with some rare exceptions have negative theta — lose value with passing time.

Theta is greatest at the money.