Greeks - Theta Explained

let's use SPY trading at $108.20 with 11 days to expiration....the following Greeks for a Long Nov 109-strike Call are :

Delta : +0.41
Gamma : +0.1
Theta : -0.06
Vega : +0.08

Theta Risks

Theta is defined as the Rate of "Decay" of any option's extrinsic premium.

A side note on option premium. All options value are composed of intrinsic and extrinsic values. For example, recall that this Long SPY Nov 109 Call is valued at $1.91, when SPY was trading at $108.20. This is an OTM Call. This $1.91, the value of this Call option, consists of $0 Intrinsic value and $1.91 of Extrinsic value.

All OTM options contain only extrinsic values. ONLY ITM options contain intrinsic values.

Thus, when you purchase this 11days to expiration Long SPY Nov 109 Call, and paid $1.91, all of this is "time" fee. This is "fair" because option is a leveraged instrument, allowing you to gain control of 100 SPY shares at a fraction of the cost of actually buying SPY shares. The tradeoff, is that you pay such extrinsic value, build into the SPY options. Option trading epitomizes the saying "There ain't never a free lunch in this world !!".

Theta affects ONLY the option extrinsic value, NEVER the intrinsic value. In this example, there is $191 worth of premium to be decayed.

So, as with the above example, with a -ve 0.06 Theta, with every passing day, this option decays by $6 (0.06 x 100). You would have noticed an anomaly by now. Given that this option has only 11 days to expiration, doesn't it mean that there is only $66 ( $6 x 11 days) of decay, but with an extrinsic value of $191. So how is this possible? This is possible, because Theta does not decay in a Linear fashion. In fact, the rate of decay (aka Theta) becomes larger as time to expiration nears. It accelerates very aggressively in the last days and last moments of the option's life !!!

A very important lesson about Theta is this...

Supposing you did purchase this Long SPY Nov 109 Call and paid $1.91 and on the final day of expiration, SPY settles at $110. One would imagine making a profit from this position. This cannot be further from the truth. In fact, if SPY had ended at $110 at expiration day, this position would make a loss. By how much?

Value of 109 Call option on expiration, with SPY trade close at $110, will have a value of exactly $1. That Long SPY Nov 109 Call can be exercised into 100 shares of SPY shares at $109 and immediately be sold off in the open market for $110, profiting $1. Of cos, this Call option will be valued at $1 exactly, no more, no less..."No free lunch mantra, remember"....

So, with this SPY Call worthy of $1, and yet you paid $1.91 for it 11 days ago...tell me, how could be be a profitable trade? It is a bigger-than-burger-king-big-whopper loss of 48% !!!

But wait...just when you think this is bad...I've got worse news...Supposing SPY on expiration day closed off at $109, that Long SPY Nov 109 Call would be worth $0 !!! All of that $191 paid for that Long Call option, miraculously vanished into thin air. Talk about frustration! You've got your market direction right, no doubt about that. You entered the trade when SPY was $108.20, and 11 days later, SPY did rise to $109, and yet, you lost 100% of your capital on this trade. Ain't this a sucker trade !! Bitch it all on -ve Theta.

Now, I believe Theta has your attention and respect (sing that song...R-E-S-P-E-C-T by Donna Summers) .......this is what Theta risks is all about.... in this case, contrary to popular saying, time is not money...instead, time is your foe, when you are -ve Theta...