3. Theta

1. What is Theta?

Theta is a key concept in options trading, representing the rate of change in an option's price for each day that passes, assuming all other factors remain constant. Often referred to as time decay, Theta quantifies the amount by which the value of an option erodes or "decays" as time passes. This is because options have an expiration date, and as this date approaches, the chance of the option being profitable (in the money) decreases. Theta is typically negative for purchased options, meaning the value of the option decreases as time passes. For sellers of options, Theta works in their favor as the options they've sold decrease in value over time.

2. The Effect of Price on Theta

While the price of the underlying asset doesn't directly affect Theta, it can indirectly influence it through its impact on the "moneyness" of the option - whether it's in the money (ITM), at the money (ATM), or out of the money (OTM). Theta is typically highest for ATM options, as these options have the highest extrinsic value (value based on time and volatility rather than intrinsic value). As the option moves ITM or OTM, Theta tends to decrease, as these options have a higher intrinsic value (value based on the price of the underlying asset) and less time value to decay.

3. The Effect of Implied Volatility on Theta

Implied volatility (IV), the market's forecast of a likely movement in a security's price, has a direct impact on Theta. Higher IV indicates a greater expected price range of the underlying asset, which increases the time value of the option and, therefore, Theta. As IV increases, options become more expensive, and the rate at which the option's price decays (Theta) also increases. Conversely, if IV decreases, the expected price range of the underlying asset narrows, reducing the option's time value and Theta.

4. The Effect of Time on Theta

The passage of time has a significant impact on Theta. As an option approaches expiration, its Theta increases, reflecting the accelerating rate of time decay. This is because there's less time for the underlying asset's price to move, which increases the rate at which the option's value decays. However, it's important to note that the rate of time decay isn't linear. It accelerates as the option's expiration date approaches, meaning that Theta increases the closer the option gets to expiration. This is often referred to as "Theta burn," and it's most pronounced in the final 30 days before an option's expiration.