Theta is the idea that:
“As time passes and a call option approaches maturity, its value declines, all else equal. This is also true for most put options”
Question: Are we talking about European Options here?
If so, wouldn’t being closer to expiration increase or decrease an options value depending on how far off the money it is. Since it can only get exercised during expiration, i would think that the reduction of time would actually increase its value. Could someone explain this? Thanks.
All options. The time value is, essentially, the value of the possibility that the option could move into the money (or farther into the money); the less time until the option expires, the less scope there is for favorable price movement.
It appears that you’re confusing time value with intrinsic value. The intrinsic value depends on how far in- or out-of-the-money the option is. The time value is the possibility that the intrinsic value may increase (from wherever it is).
GOOG is trading around 1,220 this morning. How likely is it that GOOG will reach 1,300 by tomorrow? How likely is it that GOOG will reach 1,300 in six months? The more likely it is, the more the time value.
My pleasure.
I would just note that while I agree with this and believe this is what the curriculum very generally wants you to understand, deep-in-the-money European Put Options do have positive theta, so their value does increase due to the passage of time for the reason that doobsmeister states. This is why it says “most” put options, not all put options.
Good point.
Deep-in-the-money European put options suffer from the (deplorable) fact that the price of the underlying cannot drop below zero. Thus, if the price is near zero, it’s more likely that it will rise (causing the value of the put option to decrease) than that it will fall.
Thanks guys… by the way, i noticed a statement in the curriculum that may explain this. it says that the delta of a put and call move closer to -1 and 1, respectively, as time passes if they are in the money.
Magician, this makes sense as option prices become more sensitive to stock movements as they get closer to expiration.So if say a call is deep out-of-the-money, and time is passing, since it is out of the money, it won’t change by a lot since there is a low chance of it being in the money with the remaining (short ) time period. Same goes for calls. I think this statement answers my somewhat vague question.
Thanks again, guys