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Chapter 17

Theta

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Skill Takeaways: What you will learn in this chapter
  • What does theta in options mean?
  • How theta behaves with different levels of moneyness
  • The relationship between theta and time to expiry
  • Why theta matters for traders on m.Stock  

What Is Theta in Options?

Theta represents the rate at which the time value of an option erodes as it approaches its expiration date. Every option’s premium is made up of two parts:

  1. Intrinsic value – the direct difference between the option’s strike price and the current price of the underlying asset
  2. Extrinsic value – the remaining portion of the premium, impacted by time, volatility, interest rates, and dividends

Theta specifically captures the portion of extrinsic value that is linked to time. It’s expressed in currency terms. For instance, a theta of -16 implies the option premium will drop by ₹16 per day due to time decay.

  • Option buyers experience negative theta (a cost as value decays).
  • Option sellers benefit from positive theta (they profit as time erodes the premium).

This is why selling options is often referred to as a positive theta trade and buying them is considered a negative theta trade.

A diagram of a curve

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Time Value, Expiry & Time Decay

Time value reflects the buyer’s willingness to pay above intrinsic value in hopes that the option will end in-the-money. In the early days of a contract, time value is high, there’s more potential for market movement and profit.

As the option moves closer to expiry, time value decays, a process known as theta decay.

Important Note: Time decay is non-linear.

  • An option with 60 days to expiry will see slow theta decay.
  • As it hits the 30-day mark, the decay picks up.
  • In the final days, theta decay accelerates sharply, like a bicycle picking up speed downhill.

One exception: deep out-of-the-money options behave slightly differently. Their decay slows as expiry nears because there's less extrinsic value left to erode.

Theta and Moneyness

Theta behaves differently based on where the option stands relative to the current price of the underlying:

  • At-the-money (ATM) options have maximum theta.
  • In-the-money (ITM) or out-of-the-money (OTM) options carry lower theta.

A deep ITM option consists mostly of intrinsic value, so there's less extrinsic value left to decay.
A deep OTM option, on the other hand, is made up mostly of extrinsic value. It decays faster in the early stages but slows as expiration approaches due to the limited value left.

Importance of Theta for Traders

Theta has a dual impact, depending on your role:

  • For an option seller, theta is an ally. As time passes, the premium erodes, helping the seller profit from the difference.
  • For an option buyer, theta is a risk. If the underlying asset doesn’t move as expected, the premium declines just because of time.

If you're a directional trader, your aim is to profit from price movement. Here, theta loss should ideally be offset by gains in intrinsic value.

  • When expecting small moves, opt for options with lower theta, so that time decay doesn’t wipe out your modest profits.

In non-directional strategies (like selling straddles or strangles), traders rely on theta decay as the core profit engine.

  • These setups require careful balance, if the market moves against your position, you may need to adjust to gain more theta or close the position, both of which carry risks.

Things to Remember

  • Theta measures the decay in an option’s time value as expiry nears.
  • An option's value consists of intrinsic and extrinsic components.
  • Maximum theta occurs when the option is at-the-money.
  • Sellers benefit from theta as it helps them earn the difference when premium drops.

Buyers lose from theta when the underlying doesn’t move in their favour.

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