Welcome to Part 6 of my series on the Greeks. This article will focus on Theta and how it can be used to your advantage in your trading.
Options decay as time passes on, but most of the decay happens in the last 30 days of their life. The erosion of an options value in the last 30 days, and particularly in the last 20 days is very speedy. Back to basics for a second – if we buy options, we want them to go up in value and so if we sell options we want them to go down in value. It would therefore make sense to sell options that have approximately 30 days left in their life.
Depending what date in the month it is, and when expiration is, it would still be ok to sell options that have up to approximately 45 days to expiration, or even options with as low as 25 days to expiration. That’s why most selling strategies Optionetics teaches involve selling options the next month out (Calendar Spreads, Credit Spreads etc).
So when can we use Theta to our advantage? When Selling!
Almost every strategy I use in my trading involves selling options. It’s a great feeling to know one thing is for sure – the sun will come up every day, and each day it does, options are going to decay even more, which is profitable for me as a seller. If our Theta is negative it means we lose that Theta amount on the next trading day, and if Theta is positive, vice versa we make that amount.
Does this mean all my trades have a positive Theta? Unfortunately they don’t. Sometimes I need more of another Greek, and am happy to trade off a little Theta to have a lot more of another. If you have read earlier issues of this series, you may remember that Gamma and Theta always fight each other, as they both grow in value (towards the end of the month), and they always have the opposite signs to each other. So if I'm directional on a trade (i.e., my view is for the stock to go up or down rather than sideways), then I will need a positive Gamma in my overall Greeks. The cost of this will be a negative Theta (I will lose a little money from time decay), but hopefully my directional gains will far outweigh the losses from time decay.
Another way selling can help is to reduce the ‘effects’ of time decay. You may not be able to turn your Theta from negative to positive, but you certainly may be able to bring that negative theta down a lot in value, so it doesn’t affect you as much.
An example may be in a Bull Call Spread. If you didn’t sell the out of the money option in the Bull Call Spread, you would have more delta (so you’d make more money as the stock went up, because you would just have a Long Call), but you would have a higher negative Theta. Here in managing the Greeks you would start to consider the trade-offs. If you wanted to hedge against time decay (and against Volatility moves as well!), then you may choose to sell that further OTM option and make the Call a Bull Call Spread.
Manage your Theta!