This entry was posted on Sunday, March 29th, 2009 at 6:09 pm and is filed under calls and puts, double calendar spreads, how to trade options, The Greeks. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
A couple of posts back I pointed out how critical it was that if we are to learn how to trade options profitably, then we must “manage by the numbers” and trade as a business. I also introduced you to the Greeks, which I went on to explain are the numbers you need to know in order to manage your portfolio of trades profitably.
Delta you may recall measures the change which occurs in an option’s value and Gamma measures the change of an option’s Delta.
Today we move on to explore another of the Greeks, Theta and in my next post we will wrap up the Greeks with a look at all important Vega and also touch briefly on Ro.
I have just set up new positions for the month of April, and so I will explain these in the light of two of these new positions I have on the IWM index.
As time approaches expiration, the option you have acquired is losing value on a daily basis. Theta is a measurement of that loss in value. The types of positions which we will be looking to put on with the Trading Pro (previously OptionSphere) program are all Theta positive positions. With an option losing value more quickly as it approaches expiration we see this reflected as an increase in the size of Theta. The nearer we get to expiration the greater the increase in size of Theta.
So .. back to the IWM position which I put on a couple of days back. This shows a Delta of -1.49 and a Gamma of -7.11 (both pretty neutral positions) and a Theta of 4.46. So, provided the price remains within a certain range this means that I should be collecting on average $4.46 for every single day I am holding this position through to expiration. The reality is though that price is usually constantly changing and so Theta and the other variables will change along with it. The higher we find Theta then the better it is for us, because that is how we make money when we are trading options.
Now, it goes without saying that you don’t want to find yourself in the position where you have negative Theta. For example, if the above was -$4.46 then this is the amount of money on average I would be losing each day and this loss would become even greater the closer I got to the strike price of the option I’m buying.
Now, in the case of the IWM position I had put on two positions using a double calendar spread. I had purchased a 45 call and a 39 put in the the month of May with the sale of the same in the front month of April. So, in making my selection, to ensure that I did not find myself in a loss situation I had to be absolutely correct with regards both timing and direction. Now, as I say .. almost certainly the price is going to bounce around a bit and I may well find myself having to adjust my positions. But that is no big deal .. and after all .. it’s all part of the art and science of knowing how to trade options with confidence.