22 lines
1.5 KiB
Plaintext
22 lines
1.5 KiB
Plaintext
Theta
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Option prices can be broken down into two parts: intrinsic value and time
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value. Intrinsic value is easily measurable. It is simply the ITM part of the
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premium. Time value, or extrinsic value, is what’s left over—the premium
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paid over parity for the option. All else held constant, the more time left in
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the life of the option, the more valuable it is—there is more time for the
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stock to move. And as the useful life of an option decreases, so does its time
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value.
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The decline in the value of an option because of the passage of time is
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called time decay, or erosion. Incremental measurements of time decay are
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represented by the Greek letter theta (θ). Theta is the rate of change in an
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option’s price given a unit change in the time to expiration . What exactly is
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the unit involved here? That depends.
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Some providers of option greeks will display thetas that represent one
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day’s worth of time decay. Some will show thetas representing seven days
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of decay. In the case of a one-day theta, the figure may be based on a seven-
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day week or on a week counting only trading days. The most common and,
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arguably, most useful display of this figure is the one-day theta based on the
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seven-day week. There are, after all, seven days in a week, each day of
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which can see an occurrence with the potential to cause a revaluation in the
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stock price (that is, news can come out on Saturday or Sunday). The one-
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day theta based on a seven-day week will be used throughout this book. |