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Option Basics - Beware of Theta (time decay)

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At OptionsAnnex.com we always consider the probability of profit (POP) of a trade, and prefer strategies that offer a POP in excess of 90%. Given this criteria, we find selling options (strategies like credit spreads and iron condors) are far better than buying options (strategies like debit spreads and long positions).

To fully understand why, we'll use an example in which both the price and volatility were favorable to a long Put position, and yet the trade lost money. See table above.

On May 20, 2013 at the Close we purchase the PCLN Jun 830 Put for $1,955 ($19.55 x 100 shares/contract). PCLN ended the day at $842.50 with an implied volatility of 26.28% (IV from the option chain), with 32 DTE (days to expiration) for the option.

By June 17th, with just 4 DTE, the price of PCLN has dropped to $825.54; this is $4.46 ITM (in the money). If presumably the IV is at 30%, we would expect to be profitable on the position; after all, both price and IV are favorable. And yet, the option is now worth $1,253 for a loss of $702; a -36% ROC (return on capital).

How is this possible? Let's look at the effects of both Delta (price movement) and Vega (volatility movement). The average delta is -0.50 ( (0.41 + 0.58) / 2 ) and the average vega is 0.68 ( (0.98 + 0.38) / 2 ); the price drop was $16.96 ($842.5 - $825.54) and the change in IV is 3.72% (30% - 26.28%). Therefore, the delta effect is $8.40 (0.50 x 16.96) and the vega effect is $2.53 (3.72 x 0.68) for a total gain of $10.92. We would expect then a profit in excess of $1,000.

However, since we are in a Long position (this occurs whenever you buy a Put or Call), we are subject to time decay (or theta). Remember that part of the price of an option is based on DTE, and as DTE gets smaller with each passing day, the value of the option declines. This occurs exponentially as we approach expiration, so the average theta is approximately -0.64 over the 28 days (32 - 4) that have passed. Therefore, the loss due to time decay is -$17.92, and this leaves a net loss of $7.00 ($10.92 - $17.92), or -$700 on the position. If we hold the Long Put to expiration, we can only make money if PCLN drops below 810.45 (830 - 19.55).

Long positions only work when price movement occurs rapidly (using a small percentage of time in the life of the option) and/or IV explodes (which offsets the loss due to time decay). The rewards, of course, are unlimited if the above occurs, but the probability of this occurrence is low with a POP of approximately 32% (the PITM at strike 810; using strike 830 less the cost of nearly $20).

An alternative would be the Call Credit Spread (or Bear Call). If we sell the 855 Call and buy the 885 Call, we create a call credit spread in which we receive in premium $9.65 (or $965 per contract). The capital at risk is $2,035 ( (885 - 855 - $9.65) x 100), which is close to the $1,955 paid for the Long 830 Put.

After 28 days, on June 17th, the credit spread is now only worth $1.48, which represents a gain of $8.17 (or $817 per contract). This represents a 48% ROC (817 / 2035). Also, when comparing the two strategies for vega and theta, we can see that the credit spread has reduced its exposure to both by 67% (or to one-third the value), while improving its POP to approximately 68% (2035 / 3000). The credit spread is also more forgiving; it will only start to lose money when PCLN exceeds $864.35 (855 + 9.65) at expiration.

In conclusion, we have two strategies based on the same expectation in price movement of PCLN - down. However, the Long Put is at a disadvantage: it has to be right in a short period of time with increasing IV. The Call credit spread has time on its side, less affected by vega and theta, and is far more forgiving if price does not move as you expect.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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