In our quest to understand trading options for income, the topic of this article covers Theta and the difference in Monthly theta vs. Weekly theta.
What is Theta? Options are contracts with a fixed life. Therefore, as the life of an option erodes, so does a portion of its value; its extrinsic value (often called time or risk value). Theta represents that daily decay in value, which goes to zero at expiration. See chart above on Intrinsic vs. Extrinsic value
If you have previously learned about Theta, you are likely familiar with the graph depicting theta decay slowly eroding until within 30-days of expiration, when erosion starts to accelerate. We call this the ATM (at the money) Monthly Theta chart. See chart above on ATM Theta.
And perhaps you are familiar with the graph depicting theta decay eroding in a linear fashion until within 30-days of expiration, when erosion starts to flatten out creating an inflection point. We call this the OTM (out of the money) Monthly Theta chart. See chart above on OTM Theta.
What we are less likely to be familiar with is the chart depicting actual changes in theta at a given level of risk. This is a realistic view of theta, which is impacted by changing extrinsic value. After all, volatility changes on a daily basis, and this affects extrinsic value; and thereby theta.
Tasty Trade performed a test of theta on a Monthly option at 3 levels of risk: ATM (at the money), which represents a POP (probability of profit) of 50%; at 1 SD (standard deviation), which represents a POP of 68%; and at 1.5 SD, which represents a POP of 90%. They used the SPY, and looked only at the Call option. The purpose was to show that exiting the trade prior to expiration made sense since theta dramatically rose near expiration. See chart above on Monthly Theta.
This raises the question of theta and its effect on Weekly options: Will theta also display a strong rise in the last few days? So Options Annex conducted a test on the SPX using Strangles at 1 SD and 1.5 SD for the year of 2011; a year that experienced both a bull and bear period, its price ending the year exactly where it started. See chart above on Weekly Theta.
As you can see from the Weekly Theta chart, theta did not rise dramatically near expiration. It did exhibit the same ragged curve as the Monthly, but as expiration approached, theta dropped; it did not rise.
Since we are using a Strangle, as opposed to Tasty Trade using a short Call, the increase in theta from one day to the next (Friday to Monday; Tuesday to Wednesday) reflects that one side or the other (Put or Call) sees an increase in theta due to market pressure; that is, the extrinsic value is increasing on the challenged side, which impacts theta. However, in the last two days of the option's life, theta drops dramatically.
One interesting result (not shown on the charts) was comparing the P&L (profit and loss) of the weekly at 1 SD vs. 1.5 SD. Both were profitable over the year (2011), but 1.5 SD had higher profitability (over 23% higher) due to smaller losses, and a lower number of losers: 1 SD = $6,938; 1.5 SD = $8,546.
In conclusion, the Monthly Theta chart does not reflect the same results we experienced with a weekly option, as exhibited in the Weekly Theta chart. Since monthly options eventually have a week left till expiration, it is fair to conclude the behavior of theta in the monthly (in its last week) is similar to the weekly.
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.