Theta measures the time decay associated with an option, which is the amount that an option will lose each day as a result of the passage of time. In the case of at-the-money options, theta increases as the expiry of the option approaches. For options that are in- and out-of-the-money options, theta decreases as the expiry date approaches.
Theta explains the effect of time on the premium of options that have been bought or sold. The further away the expiry date of an option is, the smaller the time decay for that option will be. For obvious reasons, longer-term options are more desirable, as this gives you more of a chance for the price to swing in your favour. For an options strategy that profits from time decay, you would want to go short on shorter-term options so that the loss in value due to time happens quickly.
Vega measures the sensitivity of the price of an option to changes in volatility. It is worth noting here that it is not a synonym for volatility – just the sensitivity to changes in it. As volatility increases, the prices of all the options related to that currency pair will increase. Conversely, a decrease in volatility will cause all the options to decrease in value.
Within this range, each option has its own vega, which means that it will react to changes in volatility a bit differently. The impact of changing volatility is more acute for at-the-money options than it is for the in- or out-of-the-money options. Although the way in which vega affects calls and puts is similar, the effect is more pronounced with calls rather than puts.
Using the Greeks with Combination Trades
As well as using the Greeks for individual options, they can also be applied to positions that combine multiple options. This can be helpful in quantifying the risks associated with more complex trades. Because multiple option positions comprise a variety of risk exposures, which vary quite dramatically over time with movements in the market, it can be useful to have a simple way to understand them.
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