Hello, and welcome to this installment of "Derivatives Demystified."
Today I want to talk about Time Decay. The Greek letter used to denote this concept is "Theta." Θ is the symbol if you are looking for a creative micro-tattoo idea.
Theta is the value by which your option premium will change for every day that passes.
USDZAR is currently trading at 18.4000. Say I want to buy the right to buy USD1,000,000 at 19.0000 in 32 days. I can buy a 19.0000 strike USD call and pay a premium of ZAR1,696,000.
For every day that the market* does not move, it seems less likely that I will exercise my option. I paid too high a premium and am less likely to recoup this premium.
For every day that passes, the option premium is smaller by "theta."
We can estimate theta to be ZAR53,000**. Therefore, I expect the option's value to "erode" by ZAR53,000 daily.
No one makes investments that erode daily, so options are often called hedges or insurance contracts.
What is insured here? If I were importing USD goods and knew I had to pay in ZAR, I would have just insured the exchange rate. I know that at worst, I will pay ZAR20,696,000*** for the USD1,000,000 needed to pay for my shipment.
*Market refers to the spot exchange rate, interest rates, and volatilities.
**1,696,000 (premium) / 32 (days)
***(1,000,000 * 19.000) + 1,696,000
So how do traders profit from theta?
The trader that sold the option to you makes ZAR53,000 every day that the market does not move, and she does not need to deliver the USD to you at the strike.
At the end of the 32 days, that trader would've profited the entire ZAR1,696,000. And that's precisely the view she took. She wrote options when she expected muted market movements or ZAR strength. When she knew there were many public holidays, and weekends, no interesting political events, no news expected, and a low number of market data releases.
So she earned the theta that you paid. And she got a cute tattoo in remembrance.
Hope you enjoyed this post. Next week I'm demystifying some trading jargon - if you have ideas for me to include, that would be welcome!