Q & A. Theta. An Option’s Daily Time Decay

Hi Mark,   

Just a simple question on theta. Is the theta figured into the options pricing at the end of the day overnight or on an hourly basis?

Often with options that have 1-2 weeks time remaining it sometimes appears that the theta is actually taken into account through the trading day . Even on an hourly basis . I noticed this in a position I am holding in SPY today as the market was non-trending, option values seemed to fall on a 1-2 hour time frame .

Thanks 
dave

Good question
 
There is no simple, one-size-fits-all answer. 
When I began trading as a market maker (1977), there were no on-floor computers, and we each used theta as an 'overnight' change.  In other words, the theoretical value of an option changed from the time the markets closed one day until it opened the next.  Today, it's much more sophisticated.

Because each market maker individually controls the computer that establishes his/her bids and offers, each has the ability to establish the parameters that go into determining what those markets are.

With competing market makers making competing markets, the value of the highest bid and/or the lowest offer can change for many reasons.  One of those reasons is how the trader decides to program 'time.' 

One choice is to use real time.  i doubt many use that method today.

Another choice is to assume a 'day' is six and one-half hours long.  If using that idea, then times moves along 4x faster than real time.

A third option is to assume one week (7 days) only has five days (trading days) and to set the clock to tick at 7/5 it's normal rate.  Or this can be modified further by moving the clock more rapidly at the end of the week and slower at the beginning.

The bottom line is that you cannot know which algorithm becomes the primary one for a specific class of options.  But you can be sure it's not 'regular' time.  Ingenuity, personal preference, and who knows what else goes into programming the 'clock' used to set option values.

NOTE:  Implied volatility is much  more important than theta when it comes to establishing the value of an option.  Thus, you may have seen IV decline in a dull market, rather than a faster clock.  We may be able to see the price changes, but we cannot know which specific factor(s) the MMs tweaked to cause those changes.

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