Theta: Different Levels of Reliability
Sep 18, 2018
One of the most successful traders I've come across in my career was one that completely embraced the "positive theta" (i.e. collecting theta) philosophy. You might even say he was obsessed with it.
In options trading, if the overall portfolio level theta is positive, it is often described as “collecting.” This means the overall contribution of short premium positions offering positive theta outpaces those that might be “paying theta.”
Due to time decay, or the theoretical decline in an option’s value as expiration approaches, a “collecting” portfolio theoretically should book that expected positive theta on a daily basis.
Theoretical is a keyword because options can obviously increase in value at times too, through an increase in volatility or a significant move in the underlying stock (or both), which can neutralize the effect of positive theta.
A big reason that traders often utilize short premium strategies is that empirical research on historical data has clearly demonstrated that win rates for short premium positions consistently outperform long premium positions, all else being equal. If you want to review that topic in greater detail, we recommend this previous installment of From Theory to Practice.
Traders looking to learn more about the dynamics of positive theta will find a recent episode of Trade Logic Unlocked to their liking. The focus of the show is "theta's reliability" - particularly focusing on research related to “collecting” positions.
As the hosts of Trade Logic Unlocked remind us, a big chunk of our P/L on a daily basis theoretically comes from positive theta, especially during the first half of elapsed time on route to expiration. The chart below shows how the contribution of positive theta (as a percentage of total P/L) declines as time passes:
The above is a stark reminder of the risk-reward balance that is so integral to a successful options trading endeavor. While it may seem attractive to leverage the high win rates associated with short premium/positive theta positions, one also must keep in mind that the risks increase as we march closer to expiration. This give and take is outlined in the slide below:
As shown above, after half of the days-to-expiration have elapsed, the dynamics of positive theta position shift. As expiration gets closer, theta per day increases, but so does the positions sensitivity to movement (which is described by increasing delta and gamma). In this sense, positive theta can be viewed as “more reliable” earlier in the cycle and less reliable later.
Depending on your risk profile and approach, the above information may help you to refine your trading philosophy to help ensure that the positions deployed in your portfolio closely match the exposure(s) you want at any given moment in time.
If you are looking to better understand how overall time to expiration can affect the performance of a position, new research by tastytrade on weekly options may also be of interest. On a new episode of Market Measures, a study is presented that compares the side-by-side historical performance of options with 7 days-to-expiration versus those with 45 days-to-expiration in SPY. This research will no doubt help solidify your understanding of the respective risks and rewards associated with each approach.
Please don’t hesitate to contact us with any questions or comments by leaving a message in the space below, or sending an email to email@example.com.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastytrade is a trademark/servicemark owned by tastytrade.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).
tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.