These classes are all based on the book Trading and Pricing Financial Derivatives, available on Amazon at this link.
Hello youtube welcome back we’re back with another video in my series on the options greeks i have them all arranged as a playlist so if you want to check that out there’s a link above if you like this kind of content on youtube do subscribe and do hit the like button as well and you can hit the bell button if you want to be notified every time i put up a new
Video so this is the fourth video in our series on the greeks for option investors and in this video we’re going to learn about theta beta measures the sensitivity of options values to the passage of time this is the tendency for options prices to fall due to the passage of time and it’s also known a lot of option traders will refer to it just as time decay theta
Is the first derivative of the black scholes options pricing model with respect to time remaining to maturity theta is intuitively easy to understand longer-dated options are obviously going to be worth more than shorter dated options simply because the more time that’s left until expiration the more time there is for a big move or you know it can be a rise
Or a decline but something big has more time to occur and the option can eventually become deep in the money so let’s think a little bit about this the way that i explained it in class is to say to a student that if i were to offer to sell you a call option will say on on a stock will say apple computer and will imagine apple is trading at $100 right now and i
Say that i will sell you a call option on apple with a strike price of $200 so that is the right but not the obligation to buy it from me at $200 now it’s gonna have to more than double in value for that to become valuable now if i said to you that i would sell you that option but it expires in 15 seconds you might say well patrick i’m not gonna buy that option
From you it’s it’s worth nothing what are the odds that the biggest company in the world will double in value in the next 15 seconds that’s that’s not an option that i would pay money for now instead of it expiring in 15 seconds if i said to you well it’ll expire in 40 years you might say well actually it’s quite reasonable to think that over 40 years that a big
Stock like apple could double in value so you might actually want to buy that option from me so intuitively you can see there that with a very short expiration it seems quite unlikely that our option is going to pay off or going to be worth anything and so you you just wouldn’t pay much for it but with a very long expiration you might say well actually you know
There’s there’s loads of time for it to double in value now let’s change that and say it’s a put option and once again we’ll say apple is trading at $100 and if i said there’s there’s a put option which is the right to sell that on the right but not the obligation to sell apple stock to me at $50 so it would have to half in value it after more than half in value
In order for that option to be worth something once again if i said to you that will expire in 15 seconds you’d say well apple probably won’t half in value in the next 15 seconds but if i said 40 years expiration you would say well actually there’s a lot that can happen you know apples a great company but you know so was so was blackberry and so were a bunch of
Companies that have now disappeared so for both puts and calls you can see that the more time to expiration the more an option is worth and said so then hopefully you can understand the basically is each day takes by an option is worth less an option with 30 days left to expire is worth more than an option with 29 days left to expire and so thus as each day goes
By you’d expect your option to fall a little bit in value and daddy’s tater so traders usually look at one day tater you can you can calculate theta for any period that you want but usually people care about how much theoretically it will fall in price all other things held equal if one day passes now you can’t hedge tighter so with things like delta and so on
There’s some of our greeks they’re quite hejab ‘l you can’t really hedge theta so if you don’t want to be exposed to that idea that that an option falls in value every day you probably just shouldn’t buy options at all and you know that this is very similar to almost any kind of thing with an expiration we’ll say i often compare options to insurance policies and
You know when you buy an insurance policy on your car and it has a year left each day that goes by that that insurance contract should be worth less to you simply because it’s covering less time and so you see the same thing with with options if you’re long options equal if you’re short options it’s a bit like being the insurance company that sold that insurance
Policy if you’re short options each day that ticks by without a major move against your in your favor you’re happier there’s just less time and thus the option is worth less so hopefully this is explained teta reasonably well to you let me know in the comments below if there are any other topics that you’d like me to to cover in these videos you’ve made it to the
End so you have to hit the like button and subscribe if you’d like to see more of this stuff i’m at the moment i’m putting up a video every day once i’ve gotten a lot of this stuff up i might slow down and move to one video or week but do subscribe if you want to see them see you later bye
Transcribed from video
What is Options Theta? Time Decay in Financial Options By Patrick Boyle
