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Options trading is a much more complex form of stock trading. Essentially, options are contracts that give you the right to buy or sell a stock at a set rate by a specific date with no obligation to act on it. Like any other underlying asset, options come with risk since they are speculative by nature. That’s why it’s important to measure the risk of your options by looking at Greeks, such as theta.
Investors use theta to gain more insight into the time decay of their option contract.
The theta of an option measures the value of an option in relation to how much time is left before the expiration date. It is the option’s time decay, so it tells you how much value your option will lose on a daily basis. Theta also indicates how much the underlying asset must change for you to offset the loss in value. Generally, the closer an option gets to reaching its expiration date, the more value it will lose.
One thing to keep in mind is that when you look at theta, you assume that all other things remain constant. This includes the stock price and the implied volatility. If the underlying stock price were to drop or rise significantly, this also has a major effect on the option price.
An Example of Using Theta
The reason theta should be important to anyone looking to invest in an option is because it tells you how much money you are losing every day with an option. Using theta can help you anticipate how much value your option contract will have by the expiration date.
Theta is useful when you are deciding between a long-term and short-term option. Generally, time decay works against you when going short on an option. That’s because the price of the stock has less time to change and you are still losing money on a daily basis. You typically only short an option when you think the stock price is going to stay flat. The reason time decay tends to be more favorable when you long an option is that the stock price could majorly change.
Using theta can help you anticipate how much value your option contract will have by the expiration date.
Getting to Know the Other Greeks
Investors use other measurements named after Greek letters to determine the sensitivity of an option. Along with theta, get to know these Greeks:
- Delta: This is the measurement of the impact of the underlying asset’s change of price. With a put option, its value ranges from 0 to -100. With a call option, it ranges from 0 to 100.
- Gamma: This is the measurement of delta’s rate of change. It can help you anticipate how much you could lose or gain based on the movement of the underlying position.
- Vega: This is the measurement of the impact of a change in volatility. It looks at future volatility while delta looks at actual price changes.
Investors use theta to gain more insight into the time decay of their option contract. Prior to deciding on an option, make sure to consider what all of the Greeks are telling you.
Have you used Theta in options trading?
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