Time Value, or Theta in options—so here goes!
Let me break this down into three parts for all of you that are new to options: Why is Time value a thing? How is it calculated? Where does it go?
First the Definitions: Throughout this post I will use the terms Time Value and Theta interchangeably because they are the same thing. I will also refer to Vega, which is Theta’s Greek counterpart. Vega is the rate at which Theta evaporates.
Who is selling? Who are “they?” “They” are real people that serve an important function for the market. They “make” the market by obligating themselves to provide liquidity to you and me for the trades we want to make.
Why does Theta exist? The reason options have Time Value is because they have to. An option is a contract where the Buyer is acquiring a right and the Seller is committing to an obligation. For a contract to be valid it must be supported by consideration, therefore a Buyer must pay the Seller to ensure performance at a specified date in the future. This is why Theta is a thing—the premium is what obligates. It really is that simple.
How is that premium decided? The premium commanded by an option seller is reflective of the uncertainty in the market and the perceived likelihood of an option being in the money at the time of expiration—or in other words, the option seller’s perception of risk.
During times of flat market activity, where say for example corn trades for 30 days inside of a 10 cent range (low volatility), the sellers of options are going to be comfortable with the risk and command a relatively small payment for these contracts. It makes sense then that during times of increased daily ranges (Higher Volatility) that these sellers would be more unsure and therefore command more premium for the same obligation.
Let’s consider an ATM option under two scenarios. The first is 22 cents and the second is 45 cents. Which is more likely to end in the money? It may seem counterintuitive, but all things being equal (distance from strike, and time to expiration) the higher premium option is more likely to be in the money than the cheaper one. That is exactly what the option seller is telling us here—its more likely to go that far in price, so you have to pay me more money to take that risk. This also makes it more difficult for you and me to make money with this strike price—we had to pay more premium.
This is why a lot of times professional traders will choose to either stay in futures or will buy deep in the money options during times of high volatility—they pay less for Theta and buy more Delta, which is more manageable. Food for thought.
So now you know why Theta exists and how its priced.
Where does the premium go? Why do options suffer time decay?
If the premium demanded for an option is determined by the amount of uncertainty around it, then it follows that this premium would decrease as the certainty increases. Options expire at a specified time. As the calendar ticks toward that expiration day, the likelihood that the option will be exercised decreases, and therefore the premium commanded decreases with it. This is why the rate of decay (Vega) increases as the option nears its expiration date, usually accelerating during the last 45-30 days of an options life. Every day the odds become more clear and therefore the Time Premium (Theta) decreases faster.
So, there you have an introduction to Theta and Vega, two of the most mystifying Greeks to traders. They really are not that complicated once you realize that there is simple logic behind them.
Think in terms of uncertainty—if you see a huge premium, say to yourself “the pros are unsure of this and want more money for the risk,” and you will have a different view of options all together.
