Theta, a key to efficient options writing

FandO

Option writing (selling) is, by far, one of the most successful strategies ever.  Apart from all the statistical reasoning, the fact is that an option writer takes a trade with a negative profit profile (much higher risk vs reward). Successful, however, does not necessarily mean efficient. It is the efficient trading that brings along profitability.

To make option writing more efficient one needs to capitalise on the factor adding to the returns.

Time value decay is not a new thing. Option premium keeps reducing in value with the passage of time. As an option writer, it is beneficial as we have a sell position in the option and the value of it is reducing. So on the reruns front, we all know that it is the time value decay, popularly denoted by the Greek letter Theta, which makes options writing super successful.

The simple reason is that Theta decay is like death and taxes. It is certain. The reason behind the success of option writing is that while an unfavourable move may or may not hurt the option writer, the time value decay will keep adding to the returns with every passing pocket of time.

While being successful, most of us would that the losses in option writing are due to the fact that there is always a small possibility of a very big loss. The source of this loss is the directional move that goes against us.

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The profitable element that makes us successful in writing Theta reduces premium with every passing day but the reduction is not the same every day. The following chart will explain the speed of time value decay:

The value on the horizontal axis is the number of days left for expiry. We can see that as the days to expiry reduce to single digits, the speed of time value decay increases. Considering this, along with what we have learnt so far, we can make two different strategies based on this speed to make option writing more efficient.

1. When there is more than a week left for expiry

Option writing can be done with the help of spread —against every Call/Put sold one can buy a higher Strike Call/ Lower Strike Put to protect the sell position. This will help contain the losses in case of a big opposite move.

It is necessary because the speed of time value decay will be very slow and we may have to be in the option selling position for a longer period of time to make good money out of option selling.

Max Loss = Difference between Bought & Sold Strikes – Net Premium Received

Max Profit = Net Premium Received

This strategy gives liberty to an option writer to stay in the position as the max loss is known.

2. When there is less than a week left for expiry

As seen in the chart, the last three-four days are the ones that are faster when it comes to time value decay. So, generally one may write options with a predefined stop loss and get away with it.

I have not been a big fan of keeping the positions overnight because of a big gap up or gap down opening next the morning. This may not give us an opportunity to exit.

So, one may be better off selling options may be of strikes that are a little closer to the current market price and taking advantage of option writing opportunity during the day itself.

Thus, slight modification based on the speed of time value decay can add a lot of efficiency to option writing.

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