All bicycle riders recognize the advantage of having the wind at your back. If you can arrange your route to take advantage of this boost, it makes life infinitely easier than wrestling the breeze in your face for the journey.

In the world of options, the headwinds can come as the result of three factors-implied volatility, time to expiration, and price of the underlying instrument. The probability of a successful trade is dramatically improved if the trader can put one or more of these factors at his back.

I thought that I would discuss some concepts to keep in mind when considering trade structures. There’s no sense in needlessly fighting a headwind.

The effect of implied volatility is the most frequently overlooked factor when traders consider structuring a trade. Remember from our recent anatomy lesson that this factor impacts the extrinsic (time) component of option premium. In the case of out-of-the-money options, this extrinsic component represents the entirety of the premium.

One of the important physiologic traits of implied volatility is that it rises in times of perceived future price uncertainty and almost always returns to its historic mean once the perception of an impending potential major price movement has resolved.

It is this ebb and flow of volatility that can provide a headwind or tailwind. As an example, consider the weekly options of AMZN expiring next Friday following release of earnings on Tuesday. These options have a dramatically elevated implied volatility reflective of the potential realized price volatility that will follow earnings release.

Specific trade structures can be selected to respond negatively, positively, or not at all to the decrease in implied volatility that will inevitably follow the earnings release. In œoptionspeak, these represent the categories of vega positive, vega negative, and vega neutral option positions.

The œwind in your face trade would be, for example, for the bullish trader to buy the weekly out-of-the-money $235 strike with AMZN currently trading at $233.23. This option can be bought for $9.50 or so as I type; it consists entirely of time (extrinsic) premium at an implied volatility of 70.1%.

Within the recent past, AMZN has traded at 45% implied volatility. Assuming the bullish thesis is correct, the trader must first overcome the inevitable headwind of collapsing volatility before reaping any rewards that could result from the correct price thesis.

As an example of the œwind at your back trade, the weekly 230/240/260 call butterfly, a vega negative trade can be purchased for $2.24. It is profitable between the range of $232.25 and $247.74 at next Friday’s expiration. It benefits from decreases in implied volatility prior to the Friday expiration- a extremely high probability event if the expected bullish scenario plays out.

The third scenario, I don’t want to worry about the wind, just the price could be executed by selling the weekly 230/235 put credit spread. This spread has no significant exposure to volatility and its success is dependent almost exclusively on maintaining price above $235 by next Friday’s expiration.

The purpose of today’s blog is not to attempt to give recommendations for a specific trade. My intention is to call the trader’s attention to the impact of implied volatility to the probability of success of an option trade. Failure to understand the current position of implied volatility within its relevant historical framework for the specific underlying and to construct trades accordingly represents a major source of error for many traders.

Plan your trades to take advantage of the tailwinds. Save your energy for the unforeseen uphill slopes.

My previous article introduced the concept of “the Greeks” and their applicability to characterizing the response of an option position to changes in both price of the underlying and implied volatility- delta and vega.  There remains one additional major Greek used to help understand the impact of the passage of time on an option position; this Greek is theta.

I need to remind readers of the structure of an option price.  We discussed this anatomy in detail in last week’s posting in the discussion of vega.  Similar to vega, theta is a factor which only impacts the extrinsic (time) portion of option premium.

Theta is reflective of a unique characteristic of options.  Time, at least in our present universe, only moves in one direction.  Tomorrow there will exist one less day until expiration as compared to today.  Since the time to expiration represents one of the major inputs to the option pricing model, each day less that exists in an option contract is reflected in a lower time premium.  Harnessing the power of this “theta decay” of option prices represents a major point of advantage for option traders.

Theta measures the reaction of an individual option or multi-legged option position to the passage of time. The concept of theta is particularly helpful in more complex option positions consisting of combinations of several individual positions.  In such positions, the response to passage of time is often not intuitively obvious.  This “position theta” is calculated by simply adding the theta values of each individual option position.

For a given long option position, theta is always a negative number regardless of whether the option is a put or call.  The trader who wants to construct positive theta positions, structures that benefit from the passage of time, must include short options for at least a portion of his total position.

In order to help understand the impact of theta on a position, let us consider the AMZN July 200 call.  AMZN is currently trading around $200; the 200 strike would be the current at-the-money series.  This option is currently priced at $5.30 and has a theta of -14.2.

If price and implied volatility both remained constant until tomorrow, this option would decrease in value 14.2¢ as simply the result of passage of time.  As you begin to become familiar with these concepts, I find it easy to think in terms of options being an insurance contract.  In the case of owning a call, you have bought insurance to protect you against the risk of AMZN stock moving upwards beyond $200.  The daily premium cost for this insurance policy is the 14.2¢ that the value of the call erodes if all other factors remain static.

The sensitivity of an option’s price to theta is greatest in the at-the-money strike within an individual expiration cycle because this strike always contains the maximum dollar amount of time premium.  In addition, shorter dated options have greater rates of theta decay than longer dated options.

Theta decay is not linear, especially when considered in the framework of at-the-money options.  The classic pattern is to see relentlessly accelerating theta decay as options expiration is approached.  During the last month of an at-the-money option, time decay goes from a gentle green ski slope to a double black diamond slope in the last week of the option’s life.

The relentless and inescapable impact of “theta decay” of option positions represents a major “tailwind” for a variety of options positions and a secret advantage for the educated trader. Learning to capitalize on the relentless decay of option premium gives the knowledgeable trader a huge competitive advantage.

Dan Sheridan is preparing to teach a new advanced class:

Managing By The Greeks

starting in early September.

WE NEED YOUR HELP!

We are finalizing the course now but we would like your input of what you would like to see Dan teach so we don’t miss anything you want to learn about!

Can you please tell us what you want Dan to teach in this class?

We’ll do our best to get your questions answered in this class!

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Memorizing the Greeks

Every experienced option trader should know how to use the option greeks to evaluate their current positions as well as being able to do a “what-if?” analysis to determine what might happen to their positions given changes in price, time, or volatility.  In my experience, most newer traders (and some not-so-new ones) have not taken the time to really understand and memorize the basic, practical rules that affect their ability to analyze their trades.  Not only that, I’ve never seen a concise list of the characteristics I’ve found to be most important.

To that end, I’ve developed a list of what I consider to be the most essential rules and characteristics to remember about the greeks.  Nothing esoteric here, just practical information.

Within each category (greek) I’ve also listed the characteristics from most to least important, and sub-characteristics under each major characteristic as a sub-bullet.  (Tip: if you have trouble remembering the sub-bullets, just memorize the numbered items, since the sub-bullets follow intuitively from concept in the numbered items anyway.)

Delta

1. For each one point increase in the underlying price, the value of the delta is added to the value of the option.
   • Conversely, for each one point decrease in the price of the underlying, the value of delta is subtracted from the value of the option.
2. The delta of call options is always positive (0 to 100) and the delta of put options is always negative (0 to -100).
3. The delta of an at-the-money option is approximately .50 (calls) or -.50 (puts).
4. The delta of an option at expiration is either 0 or 100 (-100 for puts).

Gamma

1. For each one point increase in the underlying price, gamma is added to delta.
   • Conversely, for each one point decrease in the price of the underlying, the value of gamma is subtracted from delta.
2. For all positive theta positions, gamma is always negative.
   • Conversely, for all negative theta positions, gamma is always positive.
3. For out-of-the-money positions such as condors, gamma is generally small compared to delta and inconsequential, whereas gamma is generally larger and has bigger associated risk for at-the-money positions such as calendars.

Theta

1. For each day that passes, the value of theta is added to the value of the option.
2. Long option positions are theta negative (lose time value each day), while short option positions are theta positive (gain time value each day).
3. For longer term options, theta decay is slower, conversely shorter term options have faster theta decay.

Vega

1. For every 1% volatility increase in the underlying asset, the value of vega is added to the value of the option.
   • Conversely, for every 1% volatility decrease, the value of vega is subtracted from the value of the option.
2. The impact of volatility changes is greater for at-the-money options than it is for in- or out-of-the-money options.
3. The impact of volatility changes is greater for longer term options and less for shorter term options.
4. Changes in vega can have more impact (i.e. you should worry about it more) for multi-month spreads (calendars, diagonals) than for single-month spreads (verticals, condors).

Rho

1. For every 1% increase in interest rates, the value of an option increases percentage-wise by the value of rho.
   • For example, if the rho of an option is 2.5, and interest rates increase by 1% ,then the value of the option increases by 2.5%.
2. For two reasons, you can usually ignore rho for most practical purposes.  First, interest rates don’t change that often, and second, for short term options, rho is small and doesn’t have much effect.
3. Rho is more important for long term options such as LEAPs.

Profitable Trading!

 Jay Bailey
Sheridan Options Mentor