Hello investors,
I wanted to dedicate a whole post to understanding the role of theta when making your buy/sell decisions on your options.
For those new to options, theta is the amount by which the option's price declines over its life period.
An option today is worth more than the same option a month from now simply due to the longer life, all else equal. It's similar to depreciation, though caused by a totally different reason.
From CME Group:
"Theta is highest for at-the-money (ATM) options and lower the further out-the-money or in-the-money the option is. The absolute value of theta of an option that is at- or near-the-money rises as the option approaches expiration. Theta for an option that is deep in- or out- the-money falls as the option approaches expiration."
(Apologies for the unavailable pictures. Please see https://www.reddit.com/r/Midasinvestors/comments/kcpzpq/options_trading_part_iii_fighting_the_theta_decay/?utm_source=share&utm_medium=ios_app&utm_name=iossmf for the pictures.)
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"Because time-value erosion is not linear, Theta of at-the-money (ATM), just slightly out-of-the-money and in-the-money (ITM) options generally increases as expiration approaches, while Theta of far out-of-the-money (OTM) options generally decreases as expiration approaches."
For example, please note the following table of Fiverr International Ltd (FVRR), which closed at $201 on Friday 12/11/2020.
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Based on this table, we will decide 1) what strike price and 2) which expiration dates offer the most value for us.
- Deciding on the strike price
If you noticed, theta for the ATM option is the highest compared to the other 3, at -0.141 for the Medium term option. That means in 1 month, you will lose $4.23 (-$0.141*30 days = $4.23). We are trying to spend as little as possible for holding an option so this one is out.
The lowest theta is deep ITM option. However, as we discussed in the Options Trading Part I (https://www.reddit.com/r/Midasinvestors/comments/jvivvt/options_trading_part_i_which_options_to_buy/), we are trying to get the best risk/reward on each option we buy so we rule this one out as well.
We are now left with 280C and 300C options.
Based only on theta, we would choose 300C.
However, if you expect the stock price to move by a small magnitude, you would be better off with 280C. If you expect large price volatility, then 300C is the better choice. It really depends on your expected magnitude of the price movement.
2) Deciding on the expiration date
The answer to this question is dependent on your holding period.
If you are expecting the stock to appreciate in the short term, the shorter expiration date will work better.
With that said, I would caution against holding any weekly, or even monthly options because the theta decay is enormous.
As an example, consider FVRR 300C 4/16/21 (OTM 4 months to expiration).
Your initial returns graph looks like this.
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It's all nice looking until we hold it for 1 month.
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You lose a whopping 35% of value in one month.
To be holding a relatively short-period option, you want to have a relatively high conviction that your thesis on the stock will play out in a relatively short amount of time because theta decay is simply too big.
If you need a few months for the stock to play out your thesis, you probably want long-dated options, even more than 1 year to take advantage of the cap gains tax.
Personally, I don't hold onto options for too long, and never let them expire for that matter. I don't hold anything that are closer than 3-4 months to the expiration. And those shorter ones that I do hold are ones that I have very high conviction on due to a variety of reasons.
With that said, you don't want to be selling options 3 weeks into it simply because you are afraid of the theta decay. If you still have 5 months till expiration, that price appreciation can offset any theta decay you had.
Panic selling is one of the key cognitive biases that prevent most people from making profits.
The bottom line is, shorter period options are risky considering how much more theta decay plays a role compared to the intermediate and longer period options.
Theta decay alone shouldn't determine your strike price or holding period but it should certainly be considered as a part of your decision-making process, aka piecing the puzzle together per the Mosaic Theory (https://www.reddit.com/r/Midasinvestors/comments/ju7zbi/investing_philosophy_plz_read_this/).
For those who are interested in where I got the data from, below are the screenshots from IB. I'm actually considering switching to another brokerage because of their outage this past week.
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Submitted December 13, 2020 at 11:37PM by gohackthat https://ift.tt/349kezm
