Demystifying Time Decay; “Theta” the ultimate friend in expiry week

Shubham Agarwal

The expiry week is different than normal trading weeks and the thing that sets it apart most is the ‘Time Value’ i.e. theta which behaves completely different.

An F&O expiry is an important event in the life of Options instrument and the final payoff for many strategies are dependent on the last level where the instrument will close.

Expiry is majorly traded with two kinds of the forecast:

1. The range within which Expiry should occur

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2. Precise level around which expiry is expected

Both the kinds of forecasts has its own payoffs with a range expectation being a low yielding strategy; however, if a precise level is targeted for expiry and the instrument happens to settle there, the reward is very high.

But, one thing is common within both the strategies is that the Options Strategy makes money due to the faster Theta decay as the expiry approaches nearby.

In the last week of expiry, buying naked options yields lower returns as the theta decay is too fast whereas range bound strategies like Short Straddle, Short Strangle, Iron Butterfly, etc. are the ones which yield a high return as the net Greek is a short trade on theta which overrules other Greeks impact to a large extent.

Predicting a precise level for expiry is also generally targeted by strategies like Short Straddle or Butterfly which is again high yielding due to the large theta decay in our favour.

Trading for a Range of Expiry:

When trading for an expected range of expiry, the handiest tool to decide on the level might be looking at the Open Interest congestions with Highest Put OI being the support area and Highest Call OI being the resistance.

If this level coincides with other studies like Technical Analysis, it can be an added indicator of confidence. When tracking the Open Interest the important behaviour to note should also be to look at those levels should not witness un-windings.

Writing strategies without hedging needs to be followed by a strong risk management as a slight breach in levels beyond the break-even points can be extremely painful.

Targeting Precise Levels for Expiry:

Studies such as Option Pain, VWAP are generally followed by traders to help them forecast the precise level for expiry. A few unconventional strategies can also be followed when the level of expiry expected is significantly beyond the current market price.

In those cases, OTM butterflies can be very cost effective and high yielding. Selling straddles are also favourites of traders but a strong money management is required to stay in the trade as a slight adverse movement can open the risk to be unlimited.

Strike shifts to match updated forecasts for expiry level can also be an option to stay aligned with the market and generate returns.

Disclaimer: The author is CEO & Head of Research at Quantsapp Private Limited. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.