Today I want to discuss the importance of one of my favorite Greeks, and I’m not talking about Giannis Antetokounmpo. I’m talking about Theta, otherwise referred to as time decay. This is a very important concept when it comes to trading options, and this knowledge can give traders an extra quiver in their trading arsenal.
Knowing what Theta is and how it works can help you understand what the “smart money” is doing and how they approach the market. Theta is fundamental in some of my trading strategies and how I view markets.
An option’s price is made up of intrinsic value and time (extrinsic) value. The closer an option gets to its expiration date, the faster that extrinsic value erodes. That rate of decay is the option’s Theta. It represents the amount of time value that will be lost the next day.
The closer the option gets to expiration, the bigger Theta gets. And, this increase happens at an exponential rate. Here’s an example of how Theta might erode an option’s time value.
And, here’s what that would look like when plotted on a graph.
Now, whenever you buy an option (call or put), your position has a negative Theta. On the other hand, when you sell premium (call or put) you have a positive Theta. For an option buyer, Theta works against you, and for the option seller, Theta works in your favor.
Three critical aspects I analyze before making a trade are price, volume, and time. Most beginners only focus on price, which is one-dimensional. Adding the concept of time adds a third dimension to how a trader can view markets. This added dimension is even more important when trading options.
The Smart Money
The market makers selling options are considered the “smart money.” They have various sophisticated options and hedging strategies to make sure the odds are in their favor. When market makers sell a lot of call options at a specific price, they benefit if the stock stays below that price as they will pocket the premium. The opposite is true for put sellers.
Every day that the stock stays below that particular strike, the price of the options will decay due to Theta, and the options seller will be in a stronger position. This is why I look at the open interest in a stock I am interested in. I wrote more about that here. The option seller benefits from the passage of time, not only price.
I want to understand what the “smart money” is likely to do to put myself in a position of strength when making a trade. That is why I have various trading strategies that I use based on my understanding of Theta. By selling options, I can benefit not just from the movement in price but also the passage of time, just like the market makers.
One of my favorite trading strategies is selling put spreads. It takes advantage of the market’s tendency to move up for longer than it moves down and allows me to be right on a trade even if the price of a stock doesn’t move higher when I think it is likely to do so.
Selling Put Spreads
A great example of this has been my recent trading in Upstart Holdings Inc (UPST). Here is a note in Total Alpha from a few weeks ago:
Upstart Holdings Inc. (UPST) is continuing to trade in a sideways channel after a fake breakout higher that was made the other day.
Looking at the breakout higher, this is a good example of why I don’t like to chase prices that are moving quickly higher through a key level.
Many times these are just traps because the bears know there are aggressive bulls waiting for the price to spike up through there and they want you to buy the stock to get trapped in.
Current Position : STO Jul 9 115p/120p @ $2.40 – current price $2.40
Additional Trade : STO Jul 16 110p/115p @ $2.60 LMT GTC – not filled
So I sold the 120 puts and bought the 115 puts for a total premium of $2.40. When the stock spiked, I was able to exit and have the trade go according to plan.
Exit Trade : Jul 9 115p/120p vertical @ $1.05
I have made this trade a few times over the past few weeks. I’ve gotten stopped out on a couple of occasions, but then I sold farther out-of-the-money spreads for another 1-2 weeks out.
Overall it’s been a great trade because the range has held. I’ve been selling put spreads on dips and covering on rips. The stock has not gone up much but most importantly it has not gone down for very long and has stayed in the range. Thus, rather than trading price, I have traded Theta or time decay.
Theta is a fancy Greek term used to describe the time decay in an option. Time has value in an option, and as an option gets closer to expiry, it loses this extrinsic value faster and faster. Options sellers can benefit from this time decay. Theta gives added compensation to an option seller for writing options. I use various options strategies based around time decay as part of my trading process.