# Theta greek option trading strategy

A deep in the money option would have less extrinsic value to diminish, because the price would be made up of mostly intrinsic value, so the rate of decay tends to be slower.

A deep out of the money option would also have less extrinsic value, but for a different reason. The further out of the money it is, the less chance there is of it finishing in the money. The length of time until expiration also impacts the theta value, as the effect of time decay typically increases as an option gets nearer to expiration. Theta value will usually get higher the less time there is until expiration, although the exception to this is for deep out of the money options.

As mentioned above, deep out of the money options usually have very little extrinsic value, and by the time expiration gets close there's such a small amount left to decay that the theta value will probably get lower and lower. It's also worth noting that the theta value of an option is usually in direct proportion to the gamma value of that option.

Theta is particularly important for traders when they are using trading strategies for a neutral market, because those strategies are usually used specifically to make a profit out of the effects of time decay. When using these types of strategies, it's essential that the overall theta value of your position is at the appropriate value so that you can benefit from the diminishing extrinsic value. If your position is going to be negatively affected by time decay, then you will be relying on directional moves in the underlying security in order to make a profit: The loss of extrinsic value in these trades is essentially a direct expense of making the trade, and should be offset by profits made from the relevant directional moves.

As a general rule, in-the-money options will move more than out-of-the-money options , and short-term options will react more than longer-term options to the same price change in the stock. As expiration nears, the delta for in-the-money calls will approach 1, reflecting a one-to-one reaction to price changes in the stock. As expiration approaches, the delta for in-the-money puts will approach -1 and delta for out-of-the-money puts will approach 0.

Technically, this is not a valid definition because the actual math behind delta is not an advanced probability calculation.

However, delta is frequently used synonymously with probability in the options world. Usually, an at-the-money call option will have a delta of about. As an option gets further in-the-money, the probability it will be in-the-money at expiration increases as well.

As an option gets further out-of-the-money, the probability it will be in-the-money at expiration decreases. There is now a higher probability that the option will end up in-the-money at expiration.

So what will happen to delta? So delta has increased from. So delta in this case would have gone down to. This decrease in delta reflects the lower probability the option will end up in-the-money at expiration.

Like stock price, time until expiration will affect the probability that options will finish in- or out-of-the-money. Because probabilities are changing as expiration approaches, delta will react differently to changes in the stock price. If calls are in-the-money just prior to expiration, the delta will approach 1 and the option will move penny-for-penny with the stock.

In-the-money puts will approach -1 as expiration nears. If options are out-of-the-money, they will approach 0 more rapidly than they would further out in time and stop reacting altogether to movement in the stock.

Again, the delta should be about. Of course it is. So delta will increase accordingly, making a dramatic move from. So as expiration approaches, changes in the stock value will cause more dramatic changes in delta, due to increased or decreased probability of finishing in-the-money.

But looking at delta as the probability an option will finish in-the-money is a pretty nifty way to think about it. So delta in this case would have gone down to. This decrease in delta reflects the lower probability the option will end up in-the-money at expiration. Like stock price, time until expiration will affect the probability that options will finish in- or out-of-the-money. Because probabilities are changing as expiration approaches, delta will react differently to changes in the stock price.

If calls are in-the-money just prior to expiration, the delta will approach 1 and the option will move penny-for-penny with the stock. In-the-money puts will approach -1 as expiration nears. If options are out-of-the-money, they will approach 0 more rapidly than they would further out in time and stop reacting altogether to movement in the stock.

Again, the delta should be about. Of course it is. So delta will increase accordingly, making a dramatic move from.

So as expiration approaches, changes in the stock value will cause more dramatic changes in delta, due to increased or decreased probability of finishing in-the-money. But looking at delta as the probability an option will finish in-the-money is a pretty nifty way to think about it. As you can see, the price of at-the-money options will change more significantly than the price of in- or out-of-the-money options with the same expiration. Also, the price of near-term at-the-money options will change more significantly than the price of longer-term at-the-money options.

So what this talk about gamma boils down to is that the price of near-term at-the-money options will exhibit the most explosive response to price changes in the stock. But if your forecast is wrong, it can come back to bite you by rapidly lowering your delta. But if your forecast is correct, high gamma is your friend since the value of the option you sold will lose value more rapidly. Time decay, or theta, is enemy number one for the option buyer. Theta is the amount the price of calls and puts will decrease at least in theory for a one-day change in the time to expiration.

Notice how time value melts away at an accelerated rate as expiration approaches. In the options market, the passage of time is similar to the effect of the hot summer sun on a block of ice. Check out figure 2. At-the-money options will experience more significant dollar losses over time than in- or out-of-the-money options with the same underlying stock and expiration date.