The Important Time Value in Option Trading
Options traders often refer to the delta, gamma, vega, and theta of their option positions. Collectively, these terms are known as the Greeks, and they provide a way to measure the sensitivity of an option’s price to quantifiable factors. These terms may seem confusing and intimidating to new option traders. However, broken down, the Greeks refer to simple concepts that can help you better understand the risk and potential reward of an option position. Today we will focus on Theta.
As we all know, the price of an option is composed of intrinsic value and extrinsic value. In order to understand how they affect option prices, we need to understand the difference between price and value. I believe everyone is familiar with the law of value in general economic knowledge, which is the concept that value determines price, and price fluctuates around value. The price of an option also fluctuates around the value of it.Let’s take an example.
The price of beef has increased recently, one day Alice goes to the store and bought beef at $10/pound. Alice felt this price is fair and wanted to buy more, however the refrigerator was not enough to take that much. She was afraid that the price will be higher next time so Alice discussed with the seller that she wanted to come back after two weeks to buy beef and to spend 50 cents now, to buy a right to purchase beef at $10/pound within two weeks.
The seller thought that the price would rise within two weeks, and he would like to give Alice this right at the price of $1. They made a deal at $1, which means Alice paid $1 for a call option to buy beef at $10/pound over a two-week period. After a week, suppose the unit price of beef dropped to $8/pound. However, Alice suddenly became a vegetarian and didn’t want to eat beef anymore. Therefore, she transferred the right to Bob.
Q: Does this option still have a price?
The answer is yes. Because it was a deal between Alice and Bob, not a gift. However, why would Bob be so silly to buy a right of $10/pound? Remember, the market price of beef now is $8/pound. The main reason is there are still one week before this right expires. What if beef price exceeds $10/pound in the next week? This is the value of this option, and the value is the price Bob paid to Alice.
Let’s look at another situation. The price of beef has reached $15/pound a week later. At this time, Alice was still a vegetarian, so she transferred this power to Bob. What is the value of this right at this time? Obviously, this right has a value of $15-$10=$5 at this time, because if Bob exercises this power now, he can save $5 more than buying directly from the market. This $5 plus the time value constitutes the price when buys this option.
It can be seen from the above example. Premium can be divided into two parts: intrinsic value and extrinsic value. The intrinsic value is the difference between the underlying price and the exercise price, and the intrinsic value is greater than or equal to 0.If the exercise price is higher than the market price of the underlying asset, then this option does not have intrinsic value.
Intrinsic value = underlying price-exercise price
The extrinsic value consists of time value and volatility value, where the price of the underlying asset has a volatile probability value until the option expires.
You can think of the premium as a ball floating in the water, and the water surface is the exercise price. The part exposed on the water is the intrinsic value, and the part below the water is the time value. If you press the ball hard and the ball slowly sinks into the water, the intrinsic value is slowly decreasing. After the ball is completely submerged in the water, the option has no intrinsic value and only extrinsic value remains.It is worth noting that, as the ball sinks, it is gradually getting smaller (becoming cheaper), and will get smaller and smaller as time goes by (the expiration date approaches).As can be seen, the extrinsic value decreases as the expiration date approaches. This is called time decay. The specific parameter to measure time decay involves an option indicator called Theta.
What is the importance of Theta in option trading?
Investors who have worked for a period of time are basically aware of the importance of time value to options. The following are some practical rules of Theta:
1. The buyer’s Theta value is generally negative, and the seller’s Theta value is generally positive. Because theta represents the time decay of the option value, that is, the value of the option decreases over time until the expiry date. When the option expires, the time value is zero. This is why theta is a good thing for sellers, but not for buyers-over time, the buyer’s value will decrease, but the seller earns time value. This is why selling options is also called a positive theta transaction-as theta accelerates, the seller’s option income increases.
2. Taking an at-value option as an example, when there is still a long time before the expiration date, the loss of the option value is slower, and as the time value of the option is closer to the expiration date, the degree of loss of the time value of the option begins accelerate. As the expiration date approaches for virtual and real-value options, the degree of depletion of the time value of options gradually decreases. Therefore, if investors want to buy or sell options, it is important for them to choose the right time to close the position according to the time loss.
3. The greater the volatility, the greater the time value of the option, and the smaller the volatility, the smaller the time value of the option. Therefore, when the time value is constant, it is better for the buyer to choose options with high volatility.
4. Since time decay is not linear, as the option contract approaches the expiration date, the daily loss of the time value of is greater. Therefore, buyers should try to avoid buying short-term options, whether they are at the money, in the money or out of the money. On the contrary, the seller should try to choose the nearest ATM to sell. The seller can use the Theta value distribution feature, to realize the Delta hedging strategy.