Option Theta

suresh.wadhwani2009
Finance Junkie
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Joined: Sat Apr 07, 2012 10:24 am

Option Theta

Postby suresh.wadhwani2009 » Thu Apr 12, 2012 8:29 pm

Pls explain:

Which type of option experiences accelerating time decay as expiration approaches in an unchanged market?
(i) In the money option
(ii) Out the money
(iii) At the money

In solutions it is given "At the money" but I think it should be "Out the money option" Because OTM option is running out of the time and the stock has to make its move quickly to get into the money so it should have high theta in comparison to ITM option.

Pls tell me if there is any gap in my understanding.

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content.pristine
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Posts: 356
Joined: Wed Apr 11, 2012 11:26 am

Re: Option Theta

Postby content.pristine » Mon Apr 16, 2012 3:24 pm

Hi Suresh,

Theta is basically the change in the price of an option with the passage of time. Theta is negative for American options. If you look at a graph for Theta, it is most negative for options at the money.

Coming to your question, the question states "in an unchanged market" meaning that the stock price is not going to move much.
The value of an at-the-money option changes most with the passage of time. This is because, the time value of an at the money option has a higher dollar value as that in an out-of-the-Money Option. Think about this point logically, wouldn't you pay more for the TIME VALUE of a call option at $100 or $110? Of course, you would pay more money for the time value of $100 call than one at $110 because it has a higher probability of getting in-the-money in the future.
Now, since both of these options would have its time value =0 at expiry, since the dollar value of the time value of the at-the-money option is higher, it would have to decay at a faster rate compared to the decay of the time value of the at-the-money option.

Hope this helps 8-)

suresh.wadhwani2009
Finance Junkie
Posts: 99
Joined: Sat Apr 07, 2012 10:24 am

Re: Option Theta

Postby suresh.wadhwani2009 » Mon Apr 16, 2012 5:48 pm

Thanks for the revert.

I got the point :)


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