Article Review: Option Greek Lesson: Not All Thetas are built the same.
This article, written by jbrumley is about theta in out of the money calls and puts. Link
Background
To understand the article you need to understand these terms.
“Premium”
In exchange for the rights conferred by the option, the option buyer have to pay the option seller a premium for carrying on the risk that comes with the obligation. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration.
“Expiration Date”
Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires, the right to exercise no longer exists and the stock option becomes worthless. The expiration month is specified for each option contract. The specific date on which expiration occurs depends on the type of option. For instance, stock options listed in the United States expire on the third Friday of the expiration month.
Call Option
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.
Put Option
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.
Out-of-the-Money (OTM)
Calls are out-of-the-money when their strike price is above the market price of the underlying asset.
Puts are out-of-the-money when their strike price is below the market price of the underlying asset.
Out-of-the-money options have zero intrinsic value. Their entire premium is composed of only time value. Out-of-the-money options are cheaper than in-the-money options as they possess greater likelihood of expiring worthless.
Theta
Theta is a measure of the rate of decline in the value of an option due to the passage of time.
Review
The article reviews the effect of time to expiration and the the impact of total extrinsic value on the time decay rate of “out of the money” options. The author explains why “out of the money” option have mostly extrinsic or time value and shows through charts and graphic tables how the rate of time decay or diminishing value accelerates over time as the option approaches its expiration. These tools and examples explain how these option prices rapidly decay. The author uses good graphics and common options terminology to illustrate his points.
Conclusion:
This is a good article for Options traders, particularly buyers of options, because it allows them to read and see why an investment with a fixed life span and no intrinsic value depreciates over time, and how it’s rate of depreciation accelerates or changes over time. Plus the clear mathematical certainty of it achieving zero value. Its very important for buyers of options which are out of the money and thus very cheap to understand this accelerating rate of depreciation so they buy enough time to allow the underlying asset to appreciate and so they understand the urgency of acting at certain points on the decay curve while there is still enough time value to sell with a small loss or move the position to another month. If the buyers delay they could suffer a near total loss of their investment.
It’s very depressing for buyers of out of the money options to come to terms with the large mathematical odds of failure of these investments. But on the flip side, since every transaction has a seller and a buyer, this article is very encouraging for sellers of options. Because the buyers pain is the sellers pleasure.
✍🏼 By Shortsegments.
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