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Options Time Decay Explained: Understanding Theta


Warning: options time decay can be a wonderful thing for the option seller. In fact, it is the driving force behind the so-called ‘income-generating’ strategies. The trader holds a position, waits, and then exits with a nice profit. When the position is market-neutral, all gains can be attributed to the magic of time decay.

For the option buyer, the opposite is true. By owning an option, the trader has the potential to score a big profitif the underlying asset makes the anticipated move. However, options are wasting assets and lose value each day. For the option owner, the passage of time is a negative factor and once the option is bought, the desired price movement must occur before the option expires, and the sooner the better. The underlying does not have to move to any specific price if the plan is to sell the option well before expiration (recommended). Too many option owners buy their options and hold all the way to the end, thereby sacrificing every penny paid for time premium.
 

What is Options Time Decay?

However, positions with that positive time decay are subject to losing money when the underlying asset does not behave as anticipated. These losses are directly related to negative gamma (The Greek that measures the rate at which delta changes. Negative gamma tells us that we get longer as the market falls and shorter as the market rallies.) For our waiting period to prove profitable, it is necessary for the market to ‘behave.’ Translation: The market must not stray too far from the strike prices in our position.

  • For positions where the short options have only a single strike price (calendar, butterfly, credit spread), the underlying must remain near, or move towards that strike price for maximum profit. There is leeway, but losses occur when the underlying moves to far from that strike
     
  • For positions with two such short strikes (Condor, for example), the underlying must remain between those strike price levels (preferably not near either) for the waiting period to be successful

And that’s the problem. Waiting for options to decay is ‘easy,’ but can be a risky proposition. In the real world, things are not simple. The underlying stock or index may approach the strike price of our short option(s). That can be a frightening situationespecially for the rookie trader who is experiencing this for the first time. The naturaland appropriatereaction is to relieve the fear by reducing or eliminating risk.
 

Being willing to take that defensive action is an essential part of managing risk for these positive-theta (time decay is on your side), negative-gamma trades. When things go well, traders who hold positive theta positions can make a good living. However when markets become volatile or unidirectional, losses can accumulate quickly. To survive the trader has to become a skilled risk manager.


It’s a fine line between getting out of a position that has become too risky to own and holding onto the trade for a little longer, looking for a market reversal.


The biggest problem for the rookie trader is adopting this mindset: “The market cannot move any more in this direction. Look how far it has come already. I know there is a reversal coming very soon.”


Believe me, it is an easy mindset to develop. We always prefer to believe that we made good trade decisions and that our trades will work out well in the end. And perhaps they would become profitable when all is said and done. However, the risk of substantial loss has become high; too high for the disciplined and successful trader. He knows that something bad may happen before that happy ending is reached. For example, it is not uncommon to see a stock rally to ‘squeeze the shorts’only to fall back to earth. That happens. But why take the risk? Why put yourself in position to take a big loss?


The proper mindset is: “I don’t know whether the market is moving higher or lower from here. I have a bias, but I just cannot afford to take that chance. I’m going to get out of my risky trade and take the loss. I will survive to trade (and prosper) in the future. If I want to place a wager on that market bias, I can find a far less risky way to make that play than holding onto my current (losing and risky) position.”

 

Dialog

During a discussing on position management, one trader offered the following:  Theta is how I track my progress for any trade.”

I get it. We watch the value of our account grow steadily. We watch the price of the options we sold move towards zero (or the price of the spread we own increase in value). It is so easy to believe that you discovered the Holy Grail of trading.

This euphoria can go on for a long time. Please remember this:

  • There is no free money. All trades involve risk. A winning streak can end suddenly..
     
  • Theta is the trader’s REWARD for successfully having another day pass with no relevant consequences.

Yes, you can watch the profits accrue day after day. There will be periods when the trade plan (hold and wait) works perfectly. That is not as beneficial as it seems because it may bring unrealistic (and dangerous) expectations, such as falsely believing that trading credit spreads is far too conservative and that there is so much more money to be made by selling naked options. 

When the trader does not pay for the father OTM option that completes the spread, the net premium collected is significantly larger. That increases profit potential. The difficulty is that risk has grown enormously and someone who has not lived through a violent market may go bankrupt in a heartbeat. That less-experienced trader often brushes aside all warnings because of past success.

  • As you watch the days pass and profits accumulate, it is easy to lose sight of the fact that risk (defined as the amount of money that can be lost) is just as high as it was earlier. The factor that changed as time passed is that the probability of incurring that loss is now smaller.
     
  • It only takes ONE bad day to kill the profits from weeks of collecting theta. Translation, as you continue to wait, a two standard deviation move (expected about once in every 20 trading days) could turn your winners into losers.
     
  • When a trader watches her account grow every day, she becomes blind to risk. Trust me. I have been in your shoes and watched positive theta grow my account. Then I watched as theta’s Greek counterpart (gamma) withdrew all the profits, and more, from that same account.
     
  • Warning: Recognize the danger of being mesmerized by profits. Risk is not diminished as time passes. The probability of losing has decreased, but that is not the same thing. The chance of losing does not reach zero until expiration has passed or the position has been closed.
     

Conclusion  

Please be aware of risk. Do not grow overconfident. Time decay is your friend, but it is not your savior. Owning positive theta positions can be a very profitable strategy. The warning is to be certain that you never fail to recognize just how much money can be lost from any trade.
 

Traders interested in trading options should keep in mind that the expiration date of a contract affects its value. If you’re buying options very close to their expiration date, you should be prepared for their values to drop quickly.


Traders can choose to capitalize on this by selling options close to their expiration date, but you have to be willing to accept the risks—including the potentially unlimited losses—involved with selling certain options.

 

This post was presented by Mark Wolfinger and is an extract from his book The Option Trader's Mindset: Think Like a Winner. You can buy the book at AmazonMark has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Mark has published seven books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.

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