http://livevol.blogspot.com/2014/02/so-youre-premium-seller-huh-just-love.html
Today, I'm going to expand on this concept and add to it providing additional evidence to support the idea that you are much better selling far OTM options at 60 DTE or more than you are at closer to 30 DTE.
Here is a graph depicting the theta decay curve for ATM SPX options with theoretical option prices starting at 98 DTE. As you can see based on this graph, the largest amount of decay happens right around 30 DTE and if you are selling ATM options you are certainly served best selling around 30-35 DTE. Notice the 50% drop in value over the 28 day span from 35 DTE to 7 DTE. Obviously, this is assuming all other factors are constant.
One other thing to notice on this graph is how flat the curve is from 30DTE out to 60 DTE and beyond. Yuck! That's not where you want to be when selling ATM options. You are not getting enough theta decay for your risk. That's a poor trade.
Here is a graph depicting the theta decay curve for OTM 10 delta SPX options with theoretical option prices starting at 98 DTE. Notice how much steeper the curve is for both calls and puts from 98 DTE to around 35 DTE. At 35 DTE the curve really flattens out confirming the basis of my last post, which is YOU ARE NOT DOING YOURSELF ANY FAVORS BY SELLING FAR OTM OPTIONS AT 30 DTE.
Brilliant!!
Not so fast. In options trading - as in life - everything is a trade off and there are NO free lunches. In theory that might sound like a GREAT strategy but come back to reality David because we left the dentist and you need to understand how things work in the real world.
Why isn't it such a good idea to sell premium at 90-98 DTE???
There are few reasons I will argue against selling premium this far out in the future:
- Vega risk
- Volume / open interest
- Inaccurate options model
Vega risk
The further out in time you go, the more vega risk you will have when selling premium. Given this, if you sell some relatively elevated volatility then you can make a lot of money in a very short time if the volatility comes out. However, sell mid-low volatility and you could get hammered in the short term due to your high vega risk. This could cause you to get "stuck" in the position for a very long time waiting and waiting for theta decay that just never seems to actually occur.
Either way, vega risk should be a concern if selling premium, but it gets amplified the further out in time you go and for me - the vega risk at 98 DTE is just too high compared to 60-70 DTE.
Volume / Open Interest
Now, this isn't an absolute truth across the board all the time, but generally speaking the farther out in time you go and the farther away from the money you go, the less volume and open interest you will find. That means entry into the trade could be difficult and you might not get a good fill. Worse than getting a poor fill would be getting taken to the cleaners on your exit.
Let me paint a quick picture for you: You logon and check you LVX account and notice some far OTM spreads you sold have really decayed due to price movement and volatility coming in and your up a cool 5%.
Nice! Time to cash out, collect the profits, and feel better about myself while I tell myself how smart I am. Should I plan my retirement yet? Ah, let me first put in this order right quick. You put in your order at the mid-price and wait.
... And wait.
Okay, I'll cave in a nickel you tell yourself. No big deal! Still a nice profit. You resubmit your order.
... And wait.
You cave a dime this time and crickets. NOOOOOOOOOO!!!!!
Nothing will make you curse out a market maker faster than not getting executed near mid on a profitable trade. There aren't many disappointments in the world worse than thinking you are up and ready to close a trade for your profit target only to get taken to cleaners on execution and either have to close for far less than your profit target or stay in the trade which increases your chances of giving back your gains or even catching a loss.
This is why liquidity is so important and volume and open interest can sometimes make or break a trade.
Inaccurate Options Model
In my experience and from speaking with other trades you have to know when you should trust the options model and when you should not. For example, when looking at far OTM protective puts or "units" on the options model the difference between theory and real life becomes very apparent with a flash crash or black swan event. Your little protective put will gain far more in value than the model predicts. This is an instance when the model should not be trusted. The only problem is that the only way to know this is through experience and education.
If that went right over your head, no worries... I'll explain: The model shows you that that your position should gain a certain amount of theta decay each day when selling at say 98 DTE yet the greeks don't seem to be behaving as the model predicts. You just aren't getting any decay and your actual position P/L remains stuck in the mud.
What in the heck is going on here? It's an example of a time when the model might not be as accurate as you would like and this can happen with very far OTM options when they are very far out in time among other times that are outside the scope of this post.
Okay, let's wrap it up. What timeframe is best to sell far OTM options? Based on this information the best traders I know sell far OTM premium around 60-70 DTE with a cutoff around 45 DTE. This provides the best balance of all factors including open interest/volume, vega vs. price risk, options modeling accuracy, and time spent in the trade.
Feel free to post comments or question - I'd love to hear from you!
The images (Theta decay graphs) used in this post were provided by Dave Robinson. Thanks Dave!! You can get in touch with Dave here:
Email: dtr.blogger@gmail.com
Dave also runs a great blog you should check out about building automated options trading systems, which you can find here:
No comments:
Post a Comment