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Options Time Decay Explained: Understanding Theta
Mark Wolfinger posted a article in SteadyOptions Trading Blog
For the option buyer, the opposite is true. By owning an option, the trader has the potential to score a big profit—if 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 situation—especially for the rookie trader who is experiencing this for the first time. The natural—and appropriate—reaction 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 Amazon. Mark 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. Related articles Trader Mindsets How Much Can I Earn With Options? Trader’s Mindset: Oblivious To Risks Managing A Losing Trade Maybe The Market Will Turn Around Trader’s Mindset: Always Collect Cash The Art Of Trading Decisions Managing Risk For More Than One Position My Philosophy On Options Education Trade Decisions: Risk Or Profits? The Big Loss The Options Greeks: Is It Greek To You? Options Trading Greeks: Theta For Time Decay -
This leads me to believe the market may be stuck in no-man’s land. And third, we are coming up on a double whammy for options prices. Here is what I mean by that: As I have written in the past, options prices get hit hard as one expiration cycle expires and a new options expiration becomes the front month. And this week, January options will cease to exist, and February options will be the front month. The reason for this? Let’s say you were long stock in Facebook (FB) and short a January call against it. This is the typical buy-write/covered call position. As the January call you are short expires you would look to sell a new call against your FB stock position. However, Jacob the market maker knows that this trade is coming from individual traders and from institutions. So, as the market maker, I would start lowering the price of the February options ahead of time so that I will be buying at a cheaper price when others are selling. Then, on top of that throw in the upcoming long weekend. The stock market will be closed on Monday, January 21st for Martin Luther King Day—a nice three-day weekend. But it’s not generally good for options prices. Over the course of the next couple of days, the market makers, or more likely their computer systems, are going to “push the date ahead” in all their products. So in the market makers’ pricing models, tomorrow’s date won’t be January 17th, it’s more likely to be January 21st. And as we get closer to this weekend, the computer models will move the date to January 22nd, which is the day the market opens after the holiday. The models do this to price in the decay of the day off for the holiday. That means that they will take virtually all of the decay out of the options ahead of time so that they aren’t stuck being the buyer of decaying assets over a long weekend. So how do we profit from this phenomenon? By selling options via buy-writes or option spreads like an Iron Condor. Here is the breakdown of a short volatility trade known as an Iron Condor which could work well ahead of a long holiday weekend: The Iron Condor position is the combination of a bear call spread and a bull put spread in the same underlying. It’s a strategy that’s a high probability trade, allowing for a modest profit with enough room for error. Also, it’s meant to be a directionally neutral trade, used when volatility is elevated in relation to its forecasted range. It’s my favorite volatility selling strategy. By selling a call spread and a put spread, you gain extra short volatility and decay, while at the same time limiting your risk. Here’s the hypothetical call spread: Stock XYZ is trading at 90. You’d theoretically sell the 100/105 bear call spread for $1. To execute this trade, you would: Sell the 100 calls Buy the 105 calls For a total credit of $1. Here is the graph of this trade at expiration. Here’s the hypothetical put spread: Stock XYZ is trading at 90. You’d sell the 85/80 put spread for $1. To execute this trade you would: Sell the 85 Puts Buy the 80 Puts For a total credit of $1. Here is the graph of this trade at expiration: Now we will combine these two spreads to make an Iron Condor: To do this, you simultaneously: Sell the 100 calls Buy the 105 calls For a total credit of $1. And Sell the 85 Puts Buy the 80 Puts For a total credit of $1. This would give you a total credit of $2. Here is the graph of this trade at expiration: As you can see in the chart, at expiration, you’d make $2 as long as the stock stays between 85 and 100. Meanwhile, your downside is limited to $3 if the stock goes lower than 80 or higher than 105. To learn more about these strategies and Cabot Options Trader where I use these strategies to create profits in any market visit Jacob Mintz or optionsace.com where I teach and mentor options traders. Your guide to successful options trading, Jacob Mintz
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In other words, an option premium that is not intrinsic value will decline at an increasing rate as expiration nears. The Theta is one of the most important Options Greeks. Negative theta vs. positive theta Theta values are negative in long option positions and positive in short option positions. Initially, out of the money options have a faster rate of theta decay than at the money options, but as expiration nears, the rate of theta option time decay for OTM options slows and the ATM options begin to experience theta decay at a faster rate. This is a function of theta being a much smaller component of an OTM option's price, the closer the option is to expiring. Theta is often called a "silent killer" of option buyers. Buyers, by definition, have only limited risk in their strategies together with the potential for unlimited gains. While this might look good on paper, in practice it often turns out to be death by a thousand cuts. In other words, it is true you can only lose what you pay for an option. It is also true that there is no limit to how many times you can lose. And as any lottery player knows well, a little money spent each week can add up after not hitting the jackpot for a long time. For option buyers, therefore, the pain of slowly eroding your trading capital sours the experience. When buying options, you can reduce the risk of negative theta by buying options with longer expiration. The tradeoff is smaller positive gamma, which means that the gains will be smaller if the stock moves. Option sellers use theta to their advantage, collecting time decay every day. The same is true of credit spreads, which are really selling strategies. Calendar spreads involve buying a longer-dated option and selling a nearer-dated option, taking advantage of the fact that options expire faster as they approach expiration. You can see the accelerated curve of option time decay in the following graph: As a general rule of thumb, option sellers want the underlying to stay stable, while option buyers want it to move. List of positive theta options strategies Short Call Short Put Short Straddle Short Strangle Covered Call Write Covered Put Write Long Calendar Spread Vertical Credit Spread Iron Condor Butterfly Spread List of negative theta options strategies Long Call Long Put Long Straddle Long Strangle Vertical Debit Spread Watch this video: Related articles: The Options Greeks: Is It Greek To You? Options Trading Greeks: Vega For Volatility Options Trading Greeks: Delta For Direction Options Trading Greeks: Gamma For Speed Want to learn how to put the Options Greeks to work for you? Start Your Free Trial
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The following video shows how the Theta impacts options pricing. It examines few live examples of different options strategies. Download video and slides: Options Greeks - The Theta.wmv Options Greeks Theta.pptx
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Since the markets are closed Monday, can we expect extra theta decay today to account for the long weekend? I have read conflicting opinions in various places. Both SNDK and FFIV look like good candidates for a straddle, but 3 days of theta might change the picture. Thank you. Mike