Theta Decay in Options selling: Shubham Agarwal!

Time value led drop in option premium is not a new thing to anyone. This is most popularly known as Theta Decay. Naturally Option Premium keep reducing in value with the passage of time. For an option writer (seller) it is beneficial as we have a sell position in option and value of it is reducing. So, on the reruns front, we all know that it is the theta decay popularly denoted by Greek letter Theta, is what makes Options writing very successful.

The simple reason is that theta decay is like death and taxes. It is certain. The reason behind the success of Options Writing is that while the unfavorable move may or may not create loss for the option writer, the theta decay will keep adding to the returns with every passing period.

While being successful, most of us would agree with the fact that losses in Options writing is due to a very specific fact that there is always a small possibility of a very big loss. The source of this loss is the directional move that goes against us.

Now, the profitable element of Theta that makes us successful in writing by reducing premium with every passing day does not reduce premium with the same value every day. Following chart will explain the speed of theta decay.

Horizontal axis has the number of days left for expiry. We can see that as the days to expiry reduces into the single digits the speed of theta decay starts increasing. Considering this along with what we have learnt so far as sources of losses we can make 2 approached based on different speeds to make our Option Writing better.

Approach #1 for More than 5 days left for expiry.

Option writing can be done with the help of spread. Meaning, against every Call/Put Sold one can buy Higher Strike Call/ Lower Strike Put to protect the Sell Position. This will help in restrict the losses in case of big opposite move.

It is necessary to do this because Speed of theta decay will be very slow and we may have to be in the Option Selling position for longer period of time to make good money out of Option Selling.

Max Loss = Difference between Bought & Sold Strikes – Net Premium Received

Max Profit = Net Premium Received

This approach gives liberty to Option writer to stay in the position as the max loss is known and spend more time.

Approach #2 for the week of expiry

As seen in the chart last days are the speediest when it comes to theta decay. So, generally one may write Options with a stop loss.

It’s best not to keep the positions overnight because of possible big gap up or gap down opening next day morning. This may not give us an opportunity to Exit.

So, one may be better off in Selling Options may be of strikes that are little closer to the current market price and take advantage of option writing opportunity during the day itself.

Slight modification based on speed of theta decay can add a lot of efficiency to the Option Writing.