MOST TRADERS DON’T UNDERSTAND THETA
Premium Decay, Time Decay, Theta Decay – Different names for exactly the same thing.
As our members know, our core strategy hinges on the fact that this “Theta” variable in an option contract can provide a substantial advantage to your trading in many different ways – but before we dive into to blindly selling a bunch of options to collect this elusive “Theta” profit, we must first revisit the helpful (yet boring) definition:
“The ratio of the change in an option’s price to the decrease in time to expiration. Since options are wasting assets, their value declines over time. As an option approaches its expiry date without being in the money, its time value declines because the probability of that option being profitable (in the money) is reduced.” -Investopia
As time goes by, short options profit from premium collected, while long options lose premium as time goes by; we understand this concept.
What most traders don’t understand however, is that the amount of premium we collect per day is not linear, rather it follows more of an exponential curve which accelerates greatly as the option expiration grows nearer – especially in the last 1/4 of the time cycle.
What does all this mean in terms of actually making money?? Well, if you are a newer trader, and you have been experimenting with selling options, you undoubtedly have experienced selling an option on a certain underlying and have the underlying move against you which in turn causes a panic type situation when you see your account being drained exponentially.
If you observe the graph at the top of this page, you will notice that even if the underlying is moving against you, as long as you keep a clear head, have a plan for “selling out your losses”, and remember that EVERY option experiences a dramatic loss of premium towards that last 1/4 of its life-cycle, your panic will start to subside and you will be on your way to profiting from such a move.
So to summarize, it really doesn’t matter if you are selling weekly, monthly, 6-month, 2-month, etc options, as long as you remember that what might look ugly now, could dramatically change in the last quarter of the expiration time-frame.