19 SEP 2010

Option Greek: Theta

(An overview)

Submitted to: Prf. Neeraj Gogoi

Submitted by: Ashish K Shrivastava (PGDMF023)
 Option Greeks
The mathematical characteristics of the Black-Scholes model are named after the Greek
letters used to represent them in equations. These are known as the Option Greeks. The 5
Option Greeks measure the sensitivity of the price of stock options in relation to 4
different factors;
1. Changes in the underlying stock price,
2. Interest rate,
3. Volatility,
4. Time decay.

Option Greeks allow option traders to objectively calculate changes in the value of the
option contracts in their portfolio with changes in the factors that affects the value of
stock options. The ability to mathematically calculate these changes gives option traders
the ability to hedge their portfolio or to construct positions with specific risk/reward
profiles. This alone makes knowing the Option Greeks priceless in options trading.

For the amateur trader, knowing the delta (Greek Symbol δ) of your options position is
the most important as it gives you an indication of how your option's value will change
with movements in the underlying stock price - all other variables remaining the same.
Knowing your time decay (theta θ) gives you an indication of how much time value your
options trading position is losing each day - all other variables remaining the same.

Professionals use the Option Greeks to measure exactly how much they need to hedge
their portfolio and to surgically remove specific risk factors from their portfolio. The
Option Greeks also enable the measurement of how much risk the portfolio is exposed to,
and where that risk lies (with movements in interest rates or volatility, for example).
Having a comprehensive knowledge of options Greeks is essential to long term success in
options trading.

The 5 Option Greeks are:

 Delta (Greek Symbol δ) - a measure of an option's sensitivity to changes in the price of

the underlying asset
 Gamma (Greek Symbol γ) - a measure of delta's sensitivity to changes in the price of
the underlying asset
 Vega - a measure of an option's sensitivity to changes in the volatility of the underlying
asset
 Rho (Greek Symbol ρ) - a measure of an option's sensitivity to changes in the risk free
interest rate
 Theta: a measure of an option's sensitivity to time decay
Theta:
Theta is part of option Greeks used in option trading. This defines the depreciation in the value
of option as time passes and everything else remains same. It means the option loses value even
if there is no change in any other factor as it comes closer to maturity. It defines the sensitivity of
the option with respect to time. The value of option consists of 1. Time value or Extrinsic value
2. Intrinsic value. This time value decreases (all other factor remaining constant) as the option
heads toward the maturity, mathematically time value of an option can be expressed as-

For call θc = - (δC/δt)

For put θp = - (δP/δt)

Negative sign proposes as the time passes the time to maturity decreases and hence theta
decreases. For a non dividend paying stock thetas for call and put are given by

θc = - [SN’(d1)σ/2*sqrt t]-rXe-rt*N(d2)

θp = - [SN’(d1)σ/2*sqrt t]-rXe-rt*N(-d2)

Where

N’(d) = e-0.5d^2/sqrt 2∏

d1 = [ln(S/X) + (r+σ2/2)t]/ σ sqrt t

d2 = [ln(S/X) + (r- σ2/2)t]/ σ sqrt t

 θc = Theta of the call

 θp = Theta of the put
 S = Spot price
 X = Exercise price
 r = Risk free rate of return
 t = Time to maturity

Theta for continuous dividend paying stock:

θc = - [SN’(d1)σ/2*sqrt t]-rXe-rt*N(d2)+qSe-qt*N(d1)

θp = - [SN’(d1)σ/2*sqrt t]-rXe-rt*N(-d2)-qSe-qt*N-(d1)

q= rate of continuous dividend payment

value computed through this formula is annual and as the option are majorly of shorter duration
and counted in number of days the theta is divided by 365 to deduce daily theta.
Theta is not constant and changes on daily basis in fact increases as the time to maturity
decreases. It does decrease at an even rate as well.

Long calls and long puts always have negative theta. Short calls and short puts always have
positive theta. Stock has zero theta – its value is not eroded by time. All other things being equal,
an option with more days to expiration will have more extrinsic value than an option with fewer
days to expiration. The difference between the extrinsic value of the option with more days to
expiration and the option with fewer days to expiration is due to theta. Therefore, it makes sense
that long options have negative theta and short options have positive theta. If options are
continuously losing their extrinsic value, a long option position will lose money because of theta,
while a short option position will make money because of theta.

Theta by nature of option

Theta is highest for ATM options, and is progressively lower as options are ITM and OTM. This
makes sense because ATM options have the highest extrinsic value, so they have more extrinsic
value to lose over time than an ITM or OTM option. The theta of options is higher when either
volatility is lower or there are fewer days to expiration. If you think about gamma in relation to
theta, a position of long options that has the highest positive gamma also has the highest negative
theta. There is a trade-off between gamma and theta. Think of long gamma as the stuff that
provides the power to a position to make money if the stock price starts to move big (think of a
long straddle). But theta is the price you pay for all that power. The longer the stock price does
not move big, the more theta will hurt your position.

1st Quadrant
Theta and Time
Graph of theta for an ATM call option is as follows……………

Time to maturity

4th Quadrant

S= Rs. 500, X= Rs. 500, r=6% per Annum σ=25%

Time to Maturity (Months) 3M 2.5 M 2M 1.5 M 1M 0.5 M

Theta per Annum 64.49 69.3 75.8 85.29 101.2 137.03
Theta (Rs. Per day) 0.1767 0.1899 0.2077 0.2337 0.2773 0.3754

As inferred from the above table the theta doesn’t remain constant, it grow as the time to
maturity reduces. In above case in course in 2.5 months theta increased to more than double fold.
So, we can say as the maturity approaches the value of theta goes up.

Can Theta be positive?

The answer to this question is YES. In most of the cases the value of theta for the put option will
be negative but in case of deep ITM European put options theta may be positive.

As for deep ITM put the put value will be equal to Xe-rt-S which is positive and as the time to
maturity reduced and everything else remains same the present value of exercise price goes up
and will be maximum at maturity as X-S and the put value will keep on rising. Theta would be as
a balance between the increase in price due to time value and decrease in price due to less
volatility as shrinking time to maturity. So, the theta for an European put will remain positive
until the below mentioned condition is true……

rXe-rt*N(-d2) >= SN’(d1)σ/2*sqrt t

Relationship between Theta and Gamma

There is a direct correlation between theta and gamma. When an options gamma is high, the
theta moves higher as well. When we say higher, it means theta becomes more negative which
negatively impacts the time premium for a long option holder.

Dividend Effect
The theta for a call and put at the same strike price and the same expiration month are not equal.
Without going into detail, the difference in theta between calls and puts depends on the cost of
carry for the underlying stock. When the cost of carry for the stock is positive (i.e. dividend yield
is less than the interest rate) theta for the call is higher than the put. When the cost of carry for
the stock is negative (i.e. dividend yield is greater than the interest rate) theta for the call is lower
than the put.

Portfolio Theta
Portfolio theta is sum of thetas of the option comprising the portfolio weighted with the number
of options. For the purpose of hedging it doesn’t have much significance but for a trader it
explains by what amount the value of portfolio will change even there is no change in other
factors.

Option Strategy:
Some options traders will actually play the high theta by selling shorter term options and buying
that same strike option with a greater term to maturity at the same time. They are banking on the
fact that the longer dated option will have slower time decay than the shorter dated option.

 Sell shorter term options

 Buy longer term options

Above mentioned are the two facts which theta defines to help investors in taking informed
decision.