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Theta (Θ) is one of the so-called Greeks. These are numerical indicators that traders use to measure the risks of a particular options trade.
Theta represents time-sensitivity, or time-decay. In other words, it tells you the daily rate at which an option’s value will decrease over time.
It’s helpful to think of theta in insurance terms.
Let’s say you bought health insurance.
When you’re young, fit, and healthy, your premium will likely be on the lower end of the scale. But, as you age, it’ll start increasing. This is because, as you get older, you become more prone to health issues. So the premium increases to reflect the increased risk that covering your medical bills entails.
Of course that’s not bad for both parties. You, the buyer, will have to pay more over time. But the insurer — that is, the seller — earns more.
Similarly, as options move closer to their expiry date, their value decreases. This is because, the more time passes, the less likely it becomes that the market will move enough for the option to be better value than the market price.
This — and, in turn, theta — can be positive or negative depending on your trading position.
Let’s say you wanted to bet on the Dollar going up in value against the Euro (a long position).
To do this, you’d buy an option to exchange Dollars for Euro at a strike price of USD/EUR 1.20. The option expires in three months’ time.
The idea is that, as the market exchange rate rises, you can sell your option at a profit. This is because there are people for whom the Dollar going up in value is a risk, for example because they’re US-based businesses who have to pay suppliers in a foreign currency. So, as the USD/EUR exchange rate rises, they’ll be prepared to pay more for an option that allows them to exchange Dollars for Euro at a lower rate than the market rate.
The catch is that, for your plan to work, things need to move in your favour quickly. The more time passes, the less likely the market price will move enough for your option’s strike price to be better value. Something drastic will have to happen, such as the European Central Bank deciding to devalue the Euro.
By contrast, if you took the opposite position and bet on the Dollar’s value going down (a short position) time would be on your side.
- Theta is the eighth letter of the Greek alphabet and the equivalent of the English sound ‘th’. It’s also used in trigonometry to represent an unknown variable and in geometry to represent a plane angle.
- Theta is worked out as a yearly value, but the figure most traders use is a daily rate. So, if an option has a Theta of -0.2, this means its value decreases by 20c every day.
- Theta tends to be higher in volatile markets. This is because big fluctuations in price are more likely. In comparison, Theta tends to be lower in more stable markets where fluctuations are smaller and less frequent.
Want to know more?
- This video walks you through the basics of Theta in just one minute.
- And if you want to understand Theta in more detail, this 20-minute video is a deeper dive into its ins and outs, with some useful practical examples.
Assure Hedge’s perspective
‘Theta is important because options expire. When you buy an option, what you’re really buying is insurance — an opportunity to trade at a better rate if the market doesn’t go your way. Theta tells you how well that insurance policy will sustain its value over time.‘
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