Option Theta

Theta shows how much value the option price will lose for every day that passes.

An option contract has a finite life, defined by the expiration date. As the option approaches its maturity date, an option contract's expected value becomes more certain with each day.

This Time Value, also called Extrinsic Value, represents the uncertainty of an option.

Theta is the calcuation that shows how much of this time value is eroding as each trading day passes - assuming all other inputs remain unchanged. Because of this negative impact on an option price, the Theta will always be a negative number.

For example, say an option has a theoretical price of 3.50 and is showing a Theta value of -0.20. Tomorrow, if the underlying market opens unchanged (opens at the same price as the previous days close) then the theoretical value of the option will now be worth 3.30 (3.50 - 0.20).

Option Theta

The above graph illustrates the effect on a OTM call option as it approaches maturity date. The increment as each day passes is what the Theta calculates.

You will notice that in the last remaining days of an option's life, it looses it's value quite rapidly.

This is one of the concepts traders use as a reason to short option contracts - to take advantage of this rapid rate of decay in an option's value as each trading day passes.

Comments (10)

dcclimbing

January 10th, 2013 at 5:31am

Hey Omah. The graph is of the Option Price. But because the graph is dealing with an OTM option the Time value and the Option Price are the same thing because there is no intrinsic value.

I hope that makes it clearer for you.

Peter

September 16th, 2011 at 6:51am

Nope, it is the price of the option.

I generated that graph by plotting the theoretical price of an OTM option and just changed the time to expiry until it was zero.

If it was an ITM option, the graph would be very similar except instead of falling at zero at zero days it would settle at the intrinsic value of the option.

Moha

September 16th, 2011 at 4:18am

Excuse me, but in the graph it isn't the "Option Price" but the time value of the option !

N.B: Option Price=Time Value+ Intrinsic Value

Shahrukh

October 19th, 2010 at 1:39pm

thanks

HARIOM

March 12th, 2010 at 8:15pm

Good Explanation, but theta can have positive value as well and negative values.Theta is always negative for long position positive one for short position.

HARIOM

March 12th, 2010 at 8:14pm

Good Explanation, but theta can have positive value as well and negative values.Theta is always positive for long position and negative one for short position.

Peter

January 2nd, 2010 at 3:39am

You will have to price it using an options calculator;

optiontradingtips.com/pricing/free-spreadsheet.html

neeraj

December 28th, 2009 at 6:49am

how many time value calculat for eatch day in OTM option contract

bipin

September 7th, 2009 at 6:00am

nic explanation man

jyoti

August 9th, 2009 at 11:49am

hey this was very helpful thanks a lot it is explained in simple words...........

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