In options trading, traders are often presented with Greek letters that represent mathematical measures of the sensitivity of the option price to different variables, which are products of the option pricing model, and through these measures, option traders can more accurately assess the risk exposure of the option and construct the appropriate risk management as well as trading strategies.
The Greek letters commonly used in options trading are as follows: Delta (Δ), Gamma (Γ), Theta (Θ), Vega (ν), Rho (ρ). The connotations of Theta (Θ) are described below.
Option P&L = Delta P&L + Gamma P&L + Vega P&L + Theta P&L + other small factors P&L.
Theta (Θ)
Definition: Theta is the partial derivative of the option price with respect to time.
Meaning: Theta value measures the sensitivity of an option to time and is often expressed as a negative number.
e.g. if the value of an option is 7.50 and the option has a theta of .02. After one day, the option’s value will be 7.48, 2 days 7.46. etc.
Theta is highest for at-the-money (ATM) options and lower the further out-the-money or in-the-money the option is. The absolute value of theta of an option that is at- or near-the-money rises as the option approaches expiration. Theta for an option that is deep in- or out- the-money falls as the option approaches expiration.
In the prior example, theta was a constant value of .02 for all three days. In reality, the theta loss increases as the option approaches expiration.
Application: With Theta values, option traders can better manage the expiration risk of options by selling options close to expiration to minimize Theta loss, which increases as the option approaches expiration.
