What does Theta measure in option pricing?

Theta is one of the "Greeks" used in options pricing, and it specifically measures the sensitivity of an option's price to the passage of time, also known as time decay. As an option approaches its expiration date, the time value of the option diminishes, and Theta quantifies this deterioration. For options traders, understanding Theta is crucial because it helps them assess how much the price of an option is expected to decrease as time passes, assuming all other factors remain constant.

When time to expiration decreases, the likelihood that the option will expire in-the-money diminishes, creating a natural decline in its premium. Thus, a higher Theta value indicates that an option will lose value more quickly as expiration approaches, informing traders of the risks associated with holding a long position in options contracts over time.

The context of other options involves different sensitivity measures: sensitivity to changes in market conditions would be more related to Vega, which captures volatility, while sensitivity to changes in stock price pertains to Delta. Sensitivity to changes in company valuations may touch on broader fundamental analyses but does not directly relate to the mechanics of option pricing, which is grounded in parameters such as time, price, and volatility.