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.

 
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 ]