Sunday, December 1, 2013

OTM Option Time Decay and its Exit Time

TastyTrade posted a video on Theta Based Exits for Sold Options on Youtube. It was quite educational. I’d like to share with everyone some of my review and thoughts on this topic.

On the time decay part, we sell options of delta of 0.30 to 0.35, which implies the ITM probability around 30% to 35% by expiration date. A credit is received after the option selling, which is similar to selling insurance premium. The OTM option time decay manner is somewhat different from that of ATM options which is show-cased in a lot of option text books. Based on the video introduction, the OTM option with Delta around 0.33 has a time decay chart as shown below. [Note I believe the hosts made a minor error in describing the units of the axes. The horizontal axis represent the passing time of the option in weeks (not days as they said) for an option that expires in 10 weeks. The vertical axis is the   option price x 100 in Dollars (not option price as they mentioned).]

For OTM options, the option’s price is the same as its extrinsic value. Time decay functions similar to insurance premium. This chart suggests OTM option (Delta = 0.33) price decay is relatively faster at around the first 7 weeks (49 days), which is the inflection point. After that, the time decay slows down as the price of the option has already dropped significantly and there is not much value left. The big assumption is that the OTM option stays OTM, although it was not elaborated how much price movement of the underlying could have to maintain such as time decay pattern. The discussion seemed to suggest that this 0.30 ~ 0.35 Delta OTM time decay chart is the merge of a 0.4 ~ 0.6 Delta ATM option at the 1st few weeks and a 0.1 ~ 0.2 Delta OTM option at the last few weeks.

In reality, it may be difficult to come up with the above curve for any specific options, as prices always fluctuate. Demonstrating the daily rate of return on capital (ROC) in a chart is also interesting and it can give very good clues on when to exit this type of trades. Thus, this is one area that I intend to investigate in the future with the help of ThinkScript.

On the management of winners using Theta decay for exits, I believe it’s a great rule and Tom has been telling many of his students for a long time. Once most of the premium is decayed through time, the remaining value is quite small and the rate of decay becomes very slow. From risk to reward perspective, it will not look good if we try to gain a small reward that remains in the last couple of weeks before expiration. Therefore, it makes sense to buy back the sold option in the last couple of weeks immediately after the inflection point, as the return of capital gets smaller.

TOS offers free trades for option buy-backs within a nickel. However, many options at the inflection points are likely to be worth above $0.05. Only very low priced options can meet the free commission trade criteria. It would be much helpful for retail traders if TOS could offer free buy back trades at the inflection points such as Delta <= 0.10 or price <=  $0.10 J

Where should be a good point of entry to sell the options? This is not discussed in this video. But from the chart, it appears to tell us that 8 to 7 weeks before expiration is a good entry point where the option starts to accelerate its time decay. This entry point coincides with the option selling days used by Supertrade Karen.

In summary, the video discussed option premium selling by exploring the relationship of statistical probability (success rate and occurrence rate), return on capital, and management of winners. It did not use the option Greeks that much. Even though Theta had been mentioned in the whole discussion, the value of Theta or the trend of Theta was not shown at all.

The so called “Theta based exit” should be more accurately named as “Time decay based exit” in my opinion as Theta is only one component of the time decay. The other components for time decay include implied volatility/Vega and Delta which also change with time. There is no guarantee that Theta provides the most time decay when compared to Vega and Delta.

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