Forget all the Greek talk for now, we shall go back to understand one basic concept concerning time. Assume you have enrolled for a competitive exam, you are inherently a bright candidate and have the capability to clear the exam, however if you do not give it sufficient time and brush up the concepts, you are likely to flunk the exam — so given this what is the likelihood that you will pass this exam?
Well, it depends on how much time you spend to prepare for the exam right? 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 , you buy a Nifty 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 —.
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. 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 —. 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.
Clearly time in the option sellers context acts as a risk. In such a case it probably makes sense to evaluate the time risk versus the compensation and take a call right? In fact this is what happens in real world options trading. Whenever you pay a premium for options, you are indeed paying towards —. Just to refresh your memory, let us calculate the intrinsic value for the following options assuming Nifty is at —.
We know the intrinsic value is always a positive value or zero and can never be below zero. If the value turns out to be negative, then the intrinsic value is considered zero. Hence the intrinsic values for the above options are as follows —. So given that we know how to calculate the intrinsic value of an option, let us attempt to decompose the premium and extract the time value and intrinsic value.
Have a look at the following snapshot — Details to note are as follows —. Intrinsic value of a call option — Spot Price — Strike Price i. Do you see that? The market is willing to pay a premium of Rs. Notice the overnight drop in premium value? We will soon understand why this happened. Note — In this example, the drop in premium value is This drop is attributable to drop in volatility and time. We will talk about volatility in the next chapter. For the sake of argument, if both volatility and spot were constant, the drop in premium would be completely attributable to the passage of time.
I would suspect this drop would be around Rs. Let us take another example —. You can repeat the calculation for all options both calls and puts and decompose the premium into the Time value and intrinsic value.
Time as we know moves in one direction. Keep the expiry date as the target time and think about the movement of time. Quite obviously as time progresses, the number of days for expiry gets lesser and lesser. Given this let me ask you this question — With roughly 18 trading days to expiry, traders are willing to pay as much as Rs.
Obviously they would not right? With lesser time to expiry, traders will pay a much lesser value towards time. In fact here is a snap shot that I took from the earlier months —. With 1 day to expiry, traders are willing to pay a time value of just 30 paisa. However, if the time to expiry was 20 days or more the time value would probably be Rs. This means the option buyers will pay lesser and lesser towards time value. So if the option buyer pays Rs. Now the next logical question is — by how much would the premium decrease on a daily basis owing to the passage of time?
Well, Theta the 3 rd Option Greek helps us answer this question. All options — both Calls and Puts lose value as the expiration approaches. The Theta or time decay factor is the rate at which an option loses value as time passes. Theta is expressed in points lost per day when all other conditions remain the same. A Theta of For example, if an option is trading at Rs. A 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 a positive theta. Theta is a friendly Greek to the option seller. Remember the objective of the option seller is to retain the premium. Given that options loses value on a daily basis, the option seller can benefit by retaining the premium to the extent it loses value owing to time.
For example if an option writer has sold options at Rs. Have a look at the graph below — This is the graph of how premium erodes as time to expiry approaches.
We can observe the following from the graph —. So 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.
Theta is a relatively straightforward and easy Greek to understand. We will revisit theta again when we will discuss cross dependencies of Greeks. We shall now move forward to understand the last and the most interesting Greek — Vega! Nitinji, Its a bit confusing…so what u mean to say is: If i buy options at start of series,i would always lose money at the end of expiry due to theta…then when should one be a buyer of options?
Also,according to u,what is more profitable…futures or options? So on hand if theda decreases premium value, delta or vega will increase the premium value. So it it very important to understand all the greeks and its cross dependencies. We will talk about it later in this module.
Sir, Again it is very simple and crisp explanation. Is the theta value is same for all stocks keeping all other factors same? What u have shown is drop in the premium verses time. What will be the theta value verses time?
I believe that it will change inversely and exponentially with time. Theta is friend for the seller is well understood, so if we sell a deep OTM option so that the probability of its expiring worthless is more and to pocket the premium at the expiry, may be a safe deal? Theta varies stock to stock, but certainly behaves the same for all stocks and indexes.
In fact theta increases as we process in time…so less time to expiry, the more the theta, hence more the drop in premium, by virtue of time. You are absolutely bang on the money regarding OTM options. But the question is will get the buyer for the deep OTM option?? I am novice in options. Just asking based on ur experience.. Hi kartik, Thanks for this wonderful chapter.
In one reading I almost understand the concept of chapter. Everyday I closes my position my position before 3: Please correct if am wrong. Theta does not play a big role when it comes to intraday trading. However the effect of theta is high just around expiry…so please be aware of this.
Spot Price — Strike Price i. Three days later the option is still OTM and the premium drops to Now If I square off my position. This means I am essentially closing the trade and transferring the risk of selling the option to somebody else S2 with a profit of Rs.
Let us say the person who bought the contract B1 for 90 still holds it:. S1 initially received Rs. Three days later S1 closed the position and the contract was automatically transferred to S2 for a premium of Rs. Now say the option becomes ITM and costs Rs.More...