Understanding Theta III
Brian Overby
July 5, 2006
Today I’d like to talk about theta, or time decay, as it relates to volatility and another closely related Greek, gamma. Last time we defined theta as the amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract.
Theta is also affected by volatility swings. If volatility increases theta will become a larger negative number for both near- and longer-term options. As volatility decreases theta usually becomes a smaller negative number. Put in plainer terms, then, a high-volatility option tends to lose more value due to time decay than a lower-volatility option. If you’re drawn to trading high-volatility options due to the action they bring, keep in mind that you’re also fighting time decay a bit harder with these contracts.
When you discuss theta, you should definitely think about gamma, too. In the options world, it’s all about tradeoffs - what you gain balanced against what you lose. Gamma is the Greek that is usually sacrificed to gain low theta. If you recall from the Understanding Gamma post, you can think of gamma as acceleration, an attractive quality to buyers of options, and the options with the highest gamma values are the nearest-term ATM option contracts. Moral of the story: if you want low theta, or relatively undramatic time decay, you will by default be trading an option that has low gamma or slower acceleration, too.
invest at your own risk, based on your own due diligence, at your own risk tolerance
