Archive for the ‘Future & Options’ Category

Theta Value of Options Final Part :)

Continuing the final part from where i have stopped writing……………. 🙂

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At-The-Money options have the maximum time value, because intrinsic value can begin to rise at this point.

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.The graph here indicates that the (absolute) value of Theta is highest at 2.67 for Nifty 5400 Call, which is At-The-Money (ATM) strike (which is at present the closest strike to the underlying’s spot value), as the strikes move away from ATM, and gets deep into the money or deep out of the money Theta and time value tends to decrease.

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Coming to the relationship between time value and the length of time remaining to expiration, time value of an option decays at a non-constant rate, as its expiration date approaches and becomes worthless after that date. This rate of time decay is known as Theta, which measures the amount by which option’s value decreases per day.

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Theta values are negative for all options as options are always losing time value while moving towards expiration, till options take zero time value at expiration. At expiration Theta wipes out all time value leaving the options with no value or some degree of intrinsic value. The most important characteristic of Theta is that it is not constant, as date of expiration comes closer, Theta increases, implying that the amount of time value decreasing from the option’s premium per day accelerates with each passing day.

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As you can see from the graph the rate of decay (Theta) is lower in the contracts expiring in more distant months. The August 5400 Nifty call (which has 34 Days remaining to expiry), have a Theta value of -2.67; meaning this option is losing Rs.2.67 in time value each day. This rate of decay is lower for each forward month, e.g. September 5400 call (69 days remaining to expiration) has a Theta of – 2.12. But in case of the present July 5400 call option, (with volatility and price of the underlying held constant) the rate of loss of time value accelerates as the call option gets nearer to expiration (i.e., the rate of decay is much faster on the option near to expiration than with a lot of time remaining on it). With 6 days remaining to expiration Theta is -5.03, and with 1 day remaining to expiration value of Theta has increased to 8.32.

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Considering time value and its dependence on volatility, higher volatility gives rise to higher time value as increased uncertainty about underlying’s price near expiration, tends to increase Theta.

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In conclusion, while trading options one has to consider Theta decay risk carefully as the option price may fall exponentially near expiration. However option traders can turn time value decay into profits by trading net selling option strategies which always have positive position Theta as income will be generated through time value option premiums even if the underlying remains stationary and range bound and options expire worthless. Covered Call or Covered Put Writing, Calendar Spreads, Call or Put Ratio Spreads, Call or Put Credit Spreads, Short Strangle or Straddle and even simple Call Writing and Put Writing are few common option strategies which have positive position Theta.

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