Menu
  • Option Hydra
  • Training
  • Premium
  • Courses
  • Library

Marketcalls

Simply Intelligent Technical Analysis and Trading Strategies

  • Software
    • Amibroker
    • NinjaTrader 7
    • Ninjatrader 8
    • Option Action
    • Market Analyst
    • Metatrader
    • Python
    • Datafeed
  • Market Profile
    • Orderflow
  • Markets
  • Commodities
  • Forex
  • Economy
    • Banking
  • Webinars
  • Trading Lessons
    • Algo Trading
    • Infographic
    • Video
You are here: Home / Algo Trading / THETA TRADING : Practical Approach to Trade Options Using Time Decay

THETA TRADING : Practical Approach to Trade Options Using Time Decay

February 25, 2015 by Lokesh Madan 4 Comments

THETA TRADING : Practical approach to trade options using TIME DECAY by Lokesh Madan

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, and when the market behaves, all gains can be attributed to the magic of time decay. 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 makes the position longer (more bullish) as the market falls and shorter (more bearish) 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 near to the strike price(s) of the options that were sold.

Option Greeks

 
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 prices (preferably not near either) for the waiting period to be successful.

FOR THE OPTION BUYER

The opposite is true for the option owner. When 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. Note that the underlying does not have to move to any specific price when your plan is to sell the option well before expiration (recommended). The idea is to sell the option when its price has appreciated by enough to deliver the desired profit.

Too many option owners make the mistake of buying options and holding all the way to the end, thereby sacrificing every penny paid for time premium.

RISK MANAGEMENT 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 your 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 must 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 difficulty for the rookie trader is to avoid 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.” That thought represents a financial death wish. 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. That is confirmation bias. And perhaps these will 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 to take the risk of waiting. He knows that something bad may happen and that the happy ending may never be seen. For example, it is not uncommon for 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 my current market bias, I can find a far better way to make that play than holding onto my current (money-losing and risky) position.” 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 short options move toward zero (or the price of the spread we own increase in value). It is so easy for new traders to believe that they discovered the Holy Grail of trading. That euphoria can go on for a long time. Please remember: There is no free money. All trades involve risk. A winning streak can end suddenly.

Theta is the trader’s REWARD for another day passing with no relevant consequences. Theta is the reward for taking risk and owning the winning side. 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 money to be made by selling naked options. When the trader does not buy father OTM option to complete the credit spread, the net premium collected is significantly larger. That increases profit potential. The difficulty is that risk has grown enormously—because losses are now essentially unlimited. Someone who has not lived through a violent market can go bankrupt in a heartbeat. That less-experienced trader often brushes aside all warnings because those volatile markets represent something he has never seen. 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 from your current position) has increased. 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 every 20 trading days) could turn your winners into losers. When a trader watches an account grow every day, he 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.

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. 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.

Option Theta Trader – “I know my risk at all times. I manage positions to earn money, but more importantly to maintain risk that is well within my ability to absorb any potential loss”. A time to sell premium and a time not to sell it, A time to sell theta and a time to own gamma A, time to collect daily decay, and a time to avoid it. To repeat: A proper mindset involves accepting that you do not know whether the market is moving higher or lower. You may have a bias, but cannot afford to risk holding onto high-risk positions. You will the risky position, take the loss, and survive to trade (and prosper) again. If you want to place a market wager on your bias, find a far less risky trade.

Lokesh Madan
[Source : Algotradingindia ]

Related Readings and Observations

  • High Frequency Trading Facts : Indian MarketsHigh Frequency Trading Facts : Indian Markets In India I meet so many Top broker HFT Desk their return in HFT is not so consistent. When they invested in High end technology & develop their own In house Low latency Order […]
  • My HFT Trading Story : LOKESH MADAN For me, having 15 Years experienced HFT & Quant Based Solutions & Fund management person, which I also enjoyed immensely, the market offered an opportunity to test myself and to […]
  • 7 Videos Explains What High Frequency Trading is All About7 Videos Explains What High Frequency Trading is All About High-frequency trading (HFT) is a primary form of algorithmic trading in finance. Specifically, it is the use of sophisticated technological tools and computer algorithms to rapidly trade […]
  • Using Options as Investments Tool for any asset class.Using Options as Investments Tool for any asset class. is a type of contract between 2 persons where one person grants the other person the right to buy or to sell a specific asset at a specific price within a specific time period. The most […]
  • What High Frequency Traders Do – BAD or GOOD for Markets?What High Frequency Traders Do – BAD or GOOD for Markets? Over the past few Year’s, there has been a quick shift towards algo / Quant HFT (High Frequency Trading) based trading, Where as Asset managers make 24% return in market & HFT traders make […]
  • High Frequency Trading & Market Making Heaven For Traders.High Frequency Trading & Market Making Heaven For Traders. Do you know Bombay Stock Exchange India Is going to be world best trading venue for High frequency & market making traders. Their are various reason few of them I am going to mention below.

Filed Under: Algo Trading, High Frequency Trading Tagged With: Algo Trading, HFT, Lokesh Madan, Option Greeks, Option Strategies, THETA Trading, Time Decay

Comments

  1. Raghunath says

    February 25, 2015 at 4:33 pm

    Dear Lokesh,
    Your article is insightful. I do we set stop loss for options?
    How do we back test option strategies?. What kind of setup do we need?, What kind of data we need?

    Reply
    • Lokesh Madan says

      February 26, 2015 at 8:18 pm

      Off course we must set stop loss in trading every asset classes.
      We need Level 2 data which you have to buy from NSE itself to back test Options strategies
      Rgds

      Reply
  2. Harshit Patel says

    February 26, 2015 at 10:42 pm

    Hi lokesh,

    Its a very informative article. I have been myself an option trader but never have tried theta trading, from where can a new theta trader start with .. any blog or website to follow and learn more on theta trading.

    Thanks,
    Harshit

    Reply
  3. Lokesh Madan says

    February 27, 2015 at 1:57 pm

    Buy any Options selling book as Options seller mostly focus on Theta Trading so you get all indepth information their…

    Lokesh Madan

    Reply

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Email Newsletter

Sign up to receive email updates on latest trading strategies , analysis & financial market updates

We Respect Your Privacy

Premium Access

Username:
Password:
Remember Me
Lost your password?

Tools For Traders

  • Marketcalls Android App
  • MCX Signals
  • Intraday Signals
  • International Commodities
  • OI Tracker
  • Participation OI
  • Your Broker
  • Market Sentiment Analysis

Amibroker Updates

Volatile Phases – Colorful ADX Amibroker AFL Code

November 16, 2019 By Rajandran 4 Comments

Amibroker Technical Analysis Workshop – Bangalore

November 1, 2019 By Rajandran 2 Comments

How to Send Alerts from Amibroker to Telegram Channel using Telgram API

June 12, 2019 By Rajandran 15 Comments

How to Estimate the VWAP based settlement Close like a Pro using Amibroker?

June 9, 2019 By Rajandran Leave a Comment

Practical Approach to Amibroker AFL Coding

May 23, 2019 By Rajandran 37 Comments

  • Facebook
  • Google+
  • LinkedIn
  • RSS
  • Twitter
  • YouTube

Metatrader Updates

MetaTrader 5 Demo Servers Now Available for BSE Currency Markets

March 20, 2018 By Rajandran 8 Comments

ChartIQ – WebTrader for MT4

December 4, 2017 By Rajandran 5 Comments

Metatrader 4 – Web Platform Overview

October 29, 2015 By Rajandran 9 Comments

William VIX FIX Indicator for Metatrader 4

May 16, 2015 By Rajandran 9 Comments

How to Install Custom MQL4 indicators in Metatrader

November 14, 2014 By Rajandran 7 Comments


About | Contact Us | Terms and Conditions | Privacy Policy | Support Policy | Privacy Policy | Refund Policy | Disclaimer


© Copyright 2018 Marketcalls Financial Services Pvt Ltd · All Rights Reserved · And Our Sitemap · All Logos & Trademark Belongs To Their Respective Owners·

Data and information is provided for informational purposes only, and is not intended for trading purposes. Neither marketcalls.in website nor any of its promoters shall be liable for any errors or delays in the content, or for any actions taken in reliance thereon.