Theta is one one the 4 option greeks and Theta Decay is also known as Time decay in Options which is responsible to determine the value of option premium, The premium of an OTM (Out of the Money) option consists of 2 things- "Intrinsic Value & Time value or (Theta). The Theta decay is the lowest at the beginning of the series and it increases slowly as the expiry nears and is the highest in the last 30 days on the expiry. The rate of change of Theta decay is linear at the beginning of a series and gets exponential as it approaches the expiry.
Theta
Theta is one of the 4 options Greek that determines the price of an option. Theta is also known as the Time value of an option.
The Theta plays an important part in determining the price of an Option. The option premium is mainly made up of 2 things-
Option Premium= Time value + Intrinsic Value.
In the case of an OTM (Out of the Money Option) the intrinsic value is “Zero” hence any OTM options consist of just the Theta value which is also known as the Time value.
For example, the Nifty Spot Price is 14000 and there are 5 days to expiry.
The value of the 14200 CE (call option) is 20. As this is an OTM option the intrinsic value is 0, the remaining is the Time value hence the time value for this option is Rs20. Now the option price of this Strike price on the date of expiry will be “0” if it is OTM.
Now if the price of a 1300 CE of the same expiry will be Rs120 as the Time value is 20 and the intrinsic value would be 100 as it is an ITM (In the Money Option)
Theta Decay-
The rate of decrease in the options premiums is known as the Theta Decay. As we all must have seen that the Option prices keep on decreasing as the Expiry closes in, this is due to the Theta decay or the erosion of time value. The rate of decay or decrease in the Time value of the option is quite low in the first few days of the expiry and it gradually increases as it moves to the end of the expiry. The rate of decay is linear in the beginning but gets exponential towards the end.
Theta is expressed in points lost per day hence the Value of Theta is always positive. For example, if the Theta is -0.45, it denotes that the Strike price will lose 0.45 points on a particular day. Therefore the closer the expiry gets the cheaper Option prices become as the probability of an OTM Option ending In the Money decreases over time.
Let’s understand how Theta decay works as it approaches expiry.
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At the beginning of the Series when there are 120 days for the option to expire, the Option price would be high due to the Time value, The Theta Decay at this time is “very low”. The overall decal in options could be 5%.
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In the Middle of the series, when there are 60 days to expiry the Theta Decay starts to kick in slowly but is still “Moderate”. The overall decay could range to 10-15% in this time period.
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At the End of the series when the expiry is within 30 days, the effect of Theta Decay is at its peak and is “highest” as the overall Time value has to go to “0” by the expiry day. The overall Theta decay in the last 30 days is the highest at 50-60%.
Hence, to put this into perspective we can see that Theta Decay works in the favor of Option sellers, and is also known as “Option Sellers’ Friend” as they Sell an Option at a higher price and wait patiently to enjoy the Theta decay and buy it later at a cheaper price. The ‘Theta Decay’ works against Option buyers as if the underlying asset moves against them Option Buyers will lose both in terms of Delta as well as Theta.