How to use Theta to Trade Options?
Trading in options can be tentative in nature; not having a scientific approach can be riskier than rewarding.
Carrying out good stock research is necessary to make sure derivation of maximum benefits out of options trading.
An investor involved in options trading has mathematical concepts like Theta, Delta, Gamma, Vega, etc., available to help in deciding the right time to buy and exercise an option.
How to use Theta to trade options?
Theta value or time decay is widely known as the “silent killer” for an option buyer indicates the lessening in value of the option held by the buyer as the option nears its expiration day.
In other words, as an option nears its expiration day, its time-value which is also known as extrinsic value keeps dipping until the option is considered useless after the date of expiration in this manner imposing a loss of potential returns for the option buyer with every passing day.
Whereas, Theta is a favorable position for the seller who benefits from delay in buyer’s exercise of the option.
Theta value of the option resolves the rate at which an option will decrease in value with each passing day and the value of theta for options is always negative, i.e., the time value of an option will always decrease with passing time and the value drops radically as the expiration day comes closer.
For this reason, the general strategy should be to buy options with a longer lead period to expiration to reduce the effect of time decay and minimize the Theta loss on options.
K Option strike price
N Standard normal cumulative distribution function
r Risk free interest rate
σ Volatility of the underlying
S Price of the underlying
t Time to option's expiry
In order to analyze and invest in stock trading options, online trading platforms can be utilized. Sufficient understanding of Theta can work in the favor of the investor and help minimize the time imposed loss on options.