Theta – Higher Volatility Options Strategies Part 4
Theta – Higher Volatility Options Strategies (Part 4)
Theta is also very important because we’re talking about options. So anytime you’re buying or selling anything, Theta matters. This is a simple graph of time decay. As you get closer to expiration, Theta starts to increase. The decay increases; that’s generally understood to be around that 40 days until expiration time frame, and as you get very close to expiration that acceleration increases. And I want to emphasize that, I do see a lot of presentations and educators out there who focus on that 40 day till expiration time frame as their sweet spot. There’s certainly nothing wrong with that, but one idea that gets a little lost is that even though it starts to pick up at 40 days it continues to accelerate. The rate of decay continues to accelerate all the way through expiration.
The reason why 40 days is so widely used is because a lot of investors feel like that gives you a good mixture of the rate of decay along with the actual premium itself. When you are just minutes or days away from expiration, even though you have very fast time decay, you might not see that the premium amount is worth selling. And that’s why there’s sort of an analysis done where’s that sweet spot? Now one of the things, I want to think back to the skew outline that I gave earlier. Where volatility levels are high with the lower and lowest strike prices. Theta, if you’re looking at those values on your screen, which I’ll show up on the next slide, Theta tends to be less reliable for cheap options, especially put options.
In fact for the very cheap put options, I would expect Theta to be completely inaccurate. And that’s because with put options, as I said before, if they’re worth a dime and they’re supposed to decay from one day to the next, it’s very likely that those bids stay there. Because money managers and banks and institutions are interested in downside protection and paying a little bit for it. On the flip side, very few are interested in selling those cheap options. So, if time is passing and the price is not going anywhere; then not only is Theta wrong, but in order to justify that price tomorrow, and the next day, and the next day, implied volatility levels need to go up.
If you followed what I just said there, what it means is you would expect to see a steepening of the volatility curve as you approach expiration. Simply because those cheap options hold their Value. And as time disappears with less time to expiration and option prices not changing, the only thing that can result from that is implied levels going up. I think that’s important, because you might notice that, implied volatility going up has nothing to do with an increase in demand. It’s just simply the dynamic and the mathematics behind it. Less time, same price, has to equate to imply or implied volatility levels going higher.
Here’s a look at Theta stock. It’s at 50 dollars a share, looking at the end at the money call and just seeing how that plays out from a year until expiration all the way down to a week till expiration. You can see that Theta gradually increases, and that rate of decay gets faster as you’re closer to expiration. And here again, I mentioned the OIC calculator earlier. If you want to investigate the time getting shorter and shorter, closer to expiration, a calculator is a great way to do that. Leave all of the other inputs the same, change the days till expiration, hit the recalculate button and see what does that mean? From one day to the next and how accurate is the Theta that you’re seeing on your screen. Our calculator also will show you those Greeks. So now we want to take this analysis. We have an opinion.
We know something about implied volatility, and we know something about Theta and time decay, and if we are of the opinion that we’re going to see great movement in the stock price in the future. As compared to what the market expects it to do, and I’ll say that again, greater movement in the stock price in the future, not compared to previous stock price movements, but greater than what the market expects it to do.