Friday, February 28, 2014

So you're a premium seller, huh? 

Just love sellin' that juice. 

I'm guessing you've seen this graph before showing the exponential decay of an option's value at 30 days to expiration:

Let me take another guess: After viewing this curve you immediately rushed out to fund an account and started selling far OTM call and put spreads hand over fist at 30 DTE faster than you can say, "tail risk"?

You might have planned your early retirement next.


However, do you know what the biggest mistake most premium sellers make is?

No? Well, that's obvious because you just made it.

In regards to trading options, the expressway that leads to the divine destination of consistent profitability is a long one filled with roadblocks, speed bumps, frequent pile ups, and many off ramps for those lacking discipline, fortitude, and ice in their veins. That road often starts with a new trader learning about what an option is, how to read an option chain, and the pricing model which typically leads right into two potentially dangerous topics:

1) Probability & The Bell Curve
2) Time Decay

These two topics are dangerous for many reasons, many of which are beyond the scope of this post. However, I will touch on one of those reasons. Back to the point: Anyone that has gone through the basic teachings on these topics typically makes a grave mistake. This sets me up nicely to finally answer the question, "Do you know what the biggest mistake most options premium sellers make is?

They sell far OTM options and expect the time decay to behave like ATM options. 

Classic rookie mistake.

It often sounds something like this, "Why the heck won't these far OTM options decay?! The theta just isn't coming in like the model shows it should. They are just sitting there and the market makers are killing me because they won't fill my order to take them off at $0.05. What the heck?!"

When selling far OTM options be it calls or puts you MUST understand that the time decay is going to behave much differently than your classic ATM 30 DTE exponential time decay graph. Jim Bittman does a superb job at making this point in his classic book Trading Options as a Professional and Mark Sebastian of Option Pit fame reiterates this point in his fantastic book The Option Trader's Hedge Fund on page 94 when he says, "There is a flawed belief that option time premium decays exponentially across all strikes in the final 30 days of an option's life. This is completely flawed; in the final 30 days, studies show, only ATM options decay exponentially."

Far OTM options not only decay much differently but they also tend to hold onto their value as expiration nears. To make it more clear, theta decay for ATM options accelerates exponentially in the final 30 days to expiration but theta decay for far OTM options actually decelerates in the final 30 days to expiration. Time decay for far OTM (around 10 delta) options tends to look more like this:

That is a much different picture than the previous graph and understanding how theta decay is different among various strikes and day to expiration is going to be instrumental in your success as a trader. I cannot stress this enough. If you are going to sell premium, you must understand the differences.

This information is all well and good, but information is absolutely useless without application or action. Let me repeat, INFORMATION IS ABSOLUTELY USELESS WITHOUT APPLICATION OR ACTION.

So, what's the application of this information?

Easy. When selling far OTM options you should be selling them with more than 30 DTE and often closer to 60 DTE or more and you should be taking those positions off by the time you get around 30 DTE. By doing this, you will be taking advantage of the the way far OTM options behave in terms of time decay and all other factors remaining consistent you will be getting the most time premium decay possible on a per day basis.

When I sell far OTM options I tend to sell anywhere between 50-70 DTE and I'm out of those positions by 30-45 DTE. Armed with this new information, next time you are going to sell some far OTM premium check the days to expiration and ask yourself: Is this the optimal position?

It might be, then again - you might just be making a classic rookie mistake.

No comments:

Post a Comment