Smart investors are always looking for high percentage trade setups because smart investors know they will not be right all of the time.
Credit spreads and iron condors are two very popular options trading strategies that can have success rates as high as 90%. In my own trading, I find it can be higher sometimes closer to 95%.
So what factors do we need to determine in order to find the best options to sell.
For now, it is important to understand delta, theta and time decay, or the time it takes until the option expires.
First up is delta. Now if you are new to options, I will say that the ‘greeks’ form the backbone of option pricing and activity. So right now we are going to explain DELTA.
Delta is defined as the rate of change of the price of the option with respect to it underlying security’s price. The delta ranges from 0 to 1 and reflects the price of the option in response to a 1 point ($1) movement of the underlying stock.
When you look at out of the money options, those usually have a delta closer to 0. And alternatively the closer you get to the money, the closer the delta will be to 1.
The delta also has a prime role of representing the probability of the option expiring worthless. An option with a delta of .3 has a 30% chance of expiring in the money, whereas an option with a .9 delta would have a 90% chance of expiring in the money.
Theta, delta’s often overlooked brother greek represents the rate at which the value of an option will depreciate the closer it gets to expiration. Option’s theta can also be referred to as its time decay, and it’s that time decay that works very well for the seller.
The delta I have chosen to use as an example is a delta of .15 for a call option on Facebook (FB), or whatever is closest to that number of the next 15, 30 and 45 days to expiration. All of these options are currently out of the money. I will illustrate the effect time has on the distance of the underlying that one can achieve over these time frames. These options were analyzed on 12/3/17 with the FB trading at 175 and the VIX trading at 11.43.
The first option we look at is set to expire on 12/8, just five trading days away. The option closest to the delta of .15 is the 180 call option (delta is .18) with a trading midpoint of .51. As you can see, with just five trading days until expiration the option is 5 points away from where FB is trading, or 2.9% away. The theta for this option is -.12 and that represents the rate of decay for this option.
Next, we look at options expiring on 12/22 or 19 days until expiration. An option with a delta of .15 is the $185 call option and it’s trading midpoint is .65. The option is 10 points away from the underlying and, or 5.7%. The theta for this option is -.05.
And finally we look at the options expiring in 48 days. An option with a delta of .13 for this time frame is the 205 call option and it’s midpoint value is $.18. This option is 30 points away from the underlying, or 17.14%. The theta for this option is -.01.
We are trying to illustrate three different dynamics when looking options with the roughly the same probablility over differing time frames.
First, theta represents the rate at which the value of an option will go down as expiration arrives. Always remember this – theta or time decay will accelerate the closer you get to expiration. We can see that THETA for DELTA .15 option that expires on 12/8 is -.12. This tells us that the option value will decrease by 12 cents each day that passes.
For the delta .15 expiring on 12/22 we can see that the theta is just 5 cents. Because that expiration is further into the future, theta or time decay has not begun to accelerate. We can see here that as time elapses (like sands through an hourglass) time decay has the greastest impact on the options that are closes to expiration.
The second thing we can see is that the further you go out in the calendar the more expensive an option becomes. This happens because you are paying for more ‘time premium’ the further out you go. This is known as the extrinsic value of an option. All of the options are out of the money and anything you pay for that option represents its extrinsic value because they have no ‘real’ value other than time. (you are essentially paying for hope). The more time to expiration that you sell the further you are able to move awya from the underlying stock.
The third and final thing to keep note of is adjusting your trade works better when you have more time. Things do not happen the way you would like and there will be ties when you need to adjust your trade and roll into a new strike further out into time. The more time to expiration the more time you have to keep the sold option in-the-money.
How you determine which option to sell will be based on your own risk-appetite and your view of the underlying stock: bullish, bearish or sideways. If you choose to sell the option that is closer to the strike but also closer to expiration, you will enjoy the fastest rate of time decay.
The option furthest out until expiration provides you with a cushion from the underlying stock (17.14%), but has the slowest rate of time decay at just 1 cent per day.
Each trade has its own pros and cons, and like anything has a sliding scale of risk vs reward. The shorter term trades provide for a margin of error because time is on your (the sellers) side. The market can move against your position, and you are fine as long as it remains out of the money.
The further out in time you sell an option, the less time and time decay work in your favor, but it also puts the most space between your strike price and the price of the underlying asset. And with more time, you have more opportunity to adjust your trade should it get away from you.
Delta, theta and time to expiration can be used to guide you to help select the most appropriate option to sell. Risk tolerance also plays a major role in your choice.
Good luck out there.
— The Option Specialist
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