Lesson:9 Greek Letter : 3 THETA

Time is money

Everyone must know the importance of time….. Time is Precious more value than Gold.Same way For some time Forgot all Greek letter let’s talk more on time, Invention is mother of necessity, As time passes the requirement of people differ from current status to new one. Let’s take example of Student preparing for Competitive exam and Mr. A having excellent record of education till date, Possibility of passing exam depends on time given for preparation for exam. Everyone has to brush up all concepts before appearing exam. So, Simple terms we understood the success of getting to good result is directly link with time allotted to person.

Chance of clearing exam in 2 months is more than 15 days and very much more than clearing in 5 days.

Taking same logic here, Following is situation

Nifty spot - 11100

Nifty CE option - 11500

Consider the probability of option to expire In the Money (ITM) in following given days range.

Given Nifty today at 11100, what is the chances nifty moving 400 points over next 28 days to Expire in the Money?

Answer is nifty can move 400 Points in 28 days is quite high and Possible, So chances is very high to expire In the Money.

What if there are only 15 days to expiry?

Answer is nifty can move 400 points in 15 days is reasonable time but not too high compare to 30 days.

What if there are only 5 days to expiry?

Well, 5 days,400 points, not really sure hence the likelihood of 11500 CE expiring in the money is low

What if there was only 1 day to expiry?

The probability of Nifty to move 400 points in 1 day is quite low, hence I would be reasonably certain that the option will not expire in the money, therefore the chance is ultra low.

We can easily derived that chance to become option in the money is positive correlated with time. More the time, more possibility to expire option In the money. Let’s talk more on option learning as option seller wins the game of option over a period of time. So next few minute, talking on option writer/seller.

Option seller receives the premium of option and carries unlimited risk with limited amount of premium. Now, option seller will receive reward fully if option expires out of money. Now, entire movie of option begins here- If seller sold option in beginning of month he should well aware of…..

Carries unlimited risk with respect to limited profit up to premium received

He also knows the chances of option to be in the money expire is high and he will not get his reward in case option expire in the money. As time passes, the probability of option to be in the money will reduce. Think, why should I sell option and carry huge risk? After all it is matter of time, the scope lying with time is attracting people to sell option and eat premium if option expire out of money.

Let’s check how buyer and seller come at trade off…..

Time value

Intrinsic value

In simple words, Premium is sum of time value + intrinsic value.

Time Risk
Intrinsic value of options.

In other words – Premium = Time value + Intrinsic Value

Define whether Option has value or not on expiry day.....

Nifty Spot at 10900.....

11000 CE
10800 PE
11000 PE
10800 CE

We know the intrinsic value is always a positive value or zero and can never be below zero. If the value turns out to be negative, then the intrinsic value is considered zero. We know for Call options the intrinsic value is “Spot Price – Strike Price” and for Put options it is “Strike Price – Spot Price”. Hence the intrinsic values for the above options are as follows –

11000 CE = 10900 – 11000 = - ve Hence 0
10800 PE = 10800 – 10900 = -ve Hence 0
11000 PE = 11000 – 10900 = +100
10800 CE = 10900 – 10800 = +100

Details to note are as follows –

Spot Value = 11017

Strike = 11050 CE

Status = OTM

Premium = 105

Today’s date = 20^th Aug 2019

Expiry = 29^th Aug 2019

Intrinsic value of a call option – Spot Price – Strike Price i.e 11017 – 11050 = 0 (since it’s a negative value) We know – Premium = Time value + Intrinsic value 105 = Time Value + 0 This implies Time value = 105! Do you see that? The market is willing to pay a premium of Rs.105/- for an option that has zero intrinsic value but ample time value! Recall time is money Here is snapshot of the same contract .....

Let us take another example –

Spot Value = 11017

Strike = 10950 CE

Status = ITM

Premium = 162

Today’s date = 20^thAug. 2019

Expiry = 29^th Aug 2019

Intrinsic value of call option – Spot Price – Strike Price i.e 11017 – 10950 = 67.5 We know – Premium = Time value + Intrinsic value 162 = Time Value + 67.5 This implies the Time value = 162 – 67.5 = 94.5 Hence out of the total premium of Rs.162, traders are paying 67.5 towards intrinsic value and 94.5 towards the time value. You can repeat the calculation for all options (both calls and puts) and decompose the premium into the Time value and intrinsic value.

Screenshot of Above Example here.....

Theta Screenshot:

All options – both Calls and Puts lose value as the expiration approaches. Theta is expressed in points lost per day when all other conditions remain the same. Time runs in one direction, hence theta is always a positive number, however to remind traders it’s a loss in options value it is sometimes written as a negative number. A Theta of -3 indicates that the option premium will lose -3 points for every day that passes by. For example, if an option is trading at Rs.40/- with theta of -3 then it will trade at Rs.37.00/- the following day (provided other things are kept constant). A long option (option buyer) will always have a negative theta meaning all else equal, the option buyer will lose money on a day by day basis. T+3 days there, Generally Market open at Flat will reduce premium of option by 3*3 days = 9 Rs. So, Better to buy on next week if no bigger event line up. A short option (option seller) will have a positive theta. Theta is a friendly Greek to the option seller. Remember the objective of the option seller is to retain the premium.