by Tyler Craig | April 9, 2012 12:13 pm
It’s not uncommon for discussions on the option Greeks to border on the mundane. A discourse replete with facts and figures runs the risk of becoming forgetful to the reader. Sometimes the behavior of the ever-important Greeks are best illustrated with a story. With no further ado, consider the following parable of the Theta Thief.
Though the lifespan of an option contract varies from one week to multiple years, its death date is known from inception. Following its creation by the powers that be and its listing on an options exchange, a clock begins to tick marking the passage of time until the inevitable end.
Though each option possesses a set amount of extrinsic value (sometimes called time value) when it first comes into being, a sneaky little thief called Theta relentlessly hounds the option and steals a modicum of extrinsic value every day.
At first Theta is a bit timid, only looking to steal insignificant amounts of value from the option. With months to expiration, Theta has plenty of time to pilfer from the extrinsic value stash. Over time, however, Theta’s boldness builds. With each passing day, he brazenly withdraws increasing amounts of money from the option’s dwindling supply of extrinsic value. The rate of his thievery increases at an exponential rate.
Interestingly, Theta doesn’t steal from every option at the same pace, even if they have the same expiration date. Because at-the-money options are endowed with more extrinsic value than any other strike price, they are the most susceptible to Theta’s predatory antics.
To largely inoculate themselves against Theta’s thievery, traders typically look to buy longer-dated options.
While Theta is the foe of option buyers, he acts as the friend to option sellers. As a matter of fact, all the money he is removing from the option’s value is going directly into the pocket of the option seller.
This, of course, explains in part the appeal for option-selling strategies such as covered calls and naked puts. They enable you to dispatch the sneaky thief to incrementally steal extrinsic value and deliver it directly to your brokerage account. Traders looking to maximize Theta’s pirating will look to sell shorter-dated options.
Whether you’re venturing into the options market with a penchant for speculation or risk aversion, don’t forget the role the Theta Thief will play throughout the duration of your trade.
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