Theta

Theta is used to track the rate of decay of the time value of an option. The time value of an option is the variable piece of the option’s value. Here’s an example: Suppose you identify a stock that is currently trading for $21.35 per share, and you decide to buy the $20 strike price Call options. Before buying the options, you note that the ask price for the $20 strike price Call for the current month’s expiration is $2.50 per share.

There are two components in the price of the option at the $2.50 per share ask price. Those components are the intrinsic value and the time value. The intrinsic value of the option is simply the difference between the price of the stock ($21.35 per share) and the strike price of the option ($20.00 per share), using the example above.

If the ask price for the option is $2.50 per share, and we know that the intrinsic value of the option is $1.35 per share, then we can easily deduce the time value component of the option (take the ask price of $2.50 per share and subtract the intrinsic value of $1.35 per share). This gives us a time value component of $1.15 per share.

Now, suppose you consider the $20 strike price Call for the same stock, just one month further out in time. In that case the stock price hasn’t changed, and it’s still trading for $21.35 per share. The strike price is still the $20 strike price option, but now the ask price for the option is $3.50 per share. What’s changed? The only difference in the price of the option is the time value. Since the options for next month are further away from expiration, we should expect to pay more for them.

As the option approaches its expiration date, the time value erodes more rapidly. Tracking the Theta as an option approaches expiration reveals the speed of the decay of time value. Try this: Compare the Theta for the at-the-money option for a particular stock as far out as you can go. Now compare the Theta for the at-the-money options for the next expiration month. You should notice that the Theta for the near-term options is much larger than the Theta for the longer-term options.

In addition to the Delta, Gamma, Theta previously discussed, investors also have access to another, lesser-known pair of options Greeks. These variables are primarily used by institutional money managers, but can be helpful in allowing us to forecast the potential return on our option investment, should a given price movement occur in the underlying stock.