Theta – Varsity by Zerodha

Tags

Top Highlights

• At the start of the series – when there are many days for expiry, the option does not lose much value.

• Whenever you pay a premium for options, you are indeed paying towards – Time Risk The intrinsic value of options.

• “All other things being equal, an option is a depreciating asset. The option’s premium erodes daily and this is attributable to the passage of time”.

• s we approach the expiry of the series – the effect of theta is high.

• if you are selling options at the start of the series – you have the advantage of pocketing a large premium value (as the time value is very high) but do remember the fall in premium happens at a low rate. You can sell options closer to the expiry – you will get a lower premium but the drop in premium is high, which is advantageous to the options seller.

• Time runs in one direction, hence theta is always a positive number, however, to remind traders it’s a loss in options value it is sometimes written as a negative number.

• Premium = Time value + Intrinsic Value

• Theta is expressed in points lost per day when all other conditions remain the same. Time runs in one direction, hence theta is always a positive number, however, to remind traders it’s a loss in options value it is sometimes written as a negative number.

• long option (option buyer) will always have a negative theta meaning all else equal, the option buyer will lose money on a day by day basis. A short option (option seller) will have positive theta. Theta is a friendly Greek to the option seller.

• Quite obviously higher the number of days for preparation, the higher is the likelihood of passing the exam.

• Keeping the same logic in mind, think about the following situation – Nifty Spot is 8500, you buy a Nifty 8700 Call option – what is the likelihood of this call option to expire In the Money (ITM)? Let me rephrase this question in the following way –

• Given Nifty is at 8500 today, what is the likelihood of Nifty moving 200 points over the next 30 days and therefore 8700 CE expiring ITM?

• he chance for Nifty to move 200 points over the next 30 days is quite high, hence the likelihood of an option expiring ITM upon expiry is very high

• What if there are only 15 days to expiry? An expectation that Nifty will move 200 points over the next 15 days is reasonable, hence the likelihood of an option expiring ITM upon expiry is high (notice it is not very high, but just high). What if there are only 5 days to expiry? Well, 5 days, 200 points, not really sure hence the likelihood of 8700 CE expiring in the money is low What if there was only 1 day to expiry? The probability of Nifty to move 200 points in 1 day is quite low, hence I would be reasonably certain that the option will not expire in the money, therefore the chance is ultra-low.

• Is there anything that we can infer from the above? Clearly, the more time for expiry the likelihood for the option to expire In the Money (ITM) is higher

• Now keep this point in the back of your mind as we now shift our focus on the ‘Option Seller’.

• We know an option seller sells/writes an option and receives the premium for it. When he sells an option he is very well aware that he carries an unlimited risk and limited reward potential. The reward is limited to the extent of the premium he receives. He gets to keep his reward (premium) fully only if the option expires worthless. Now, think about this – if he is selling an option early in the month he very clearly knows the following –

• He knows he carries unlimited risk and limited reward potential He also knows that by virtue of time, there is a chance for the option he is selling to transition into ITM option, which means he will not get to retain his reward (premium received)

• (although this chance gets lower and lower as time progresses towards the expiry date).

• Given this, an option seller would not want to sell options at all right? After all, why would you want to sell options when you very well know that simply because of time there is scope for the option you are selling to expire in the money