Mastering Theta

There are two things in life of which a trader can be certain: Death and theta. Option theta can be used to the advantage of a clever trader. But to be successful, there are a few things all traders must know about theta.

Time Decay

As the amount of time until expiration decreases, so does the value of the option, assuming all other pricing factors are held constant. This is intuitive when one considers that options with less time until expiration have less practical use to a trader. Therefore, as each day passes, the option has less use, and consequently less value.

While this is an obvious detriment to option buyers, it is a bona fide benefit to option sellers. Though the short option player retains the risk of volatility (in terms of gamma and vega) time always helps.

Theta Optimization

All thetas were not created equal. First, shorter-term at-the-money options have higher option thetas than their longer-term counterparts. Traders looking to squeeze the most juice out of their options find it in these shorter-term plays.

Next, at-the-money options have a higher theta than in-the-money options or out-of-the-money options. At-the-moneys are meatier in terms of time value, therefore must lose value at a faster rate.

Word to the Wise

While it seems obvious to sell the shortest-term at-the-money option to eke out the most theta, the risks can increase with these options as well. Short-term at-the-moneys also have the highest gamma. That means, stock movement as well as volatility have more of an adverse effect on these options than their alternatives. Plus, selling at-the-moneys provides less of a buffer (if the underlying moves against you) than out-of-the-money options.

Dan Passarelli

http://markettaker.com/