Collecting Theta

Positive Theta can be a Trap

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Boom or Bust. Google Images

A new option trader may daydream about buying calls and watching the price of the underlying asset soar, thereby earning several thousand dollars from a small investment. Or perhaps they dream about buying put options just before a stock market crash -- again earning enormous profits. 

That is an unrealistic way to approach the use of stock options.

The Alternative
Once traders realize that it is very difficult to earn money when buying options, they become more interested in the idea of selling options -- and hoping that the stock market does not undergo a large price change in the wrong direction. Although it is true that more professional traders earn money by selling (rather than buying) option premium, selling options can be a very risky strategy in the hands of a novice trader. Even when the trader is a skilled, experienced professional, being short naked options -- with the possibility of incurring large losses -- remains a strategy with substantial risk.

Therefore, I have a tiny number of rules to suggest for anyone who wants to own positions with positive theta.

  1. Do not sell naked call options because potential loss is unlimited (in theory, the price of the underlying stock can rise with no upper limit) and most brokers do not allow their inexperienced customers to adopt this strategy. Instead, buy one call option for each option sold. In other words, if you want to collect cash by selling calls, trade a call credit spread
     
  2. Do not sell naked put options. However, if you want to buy shares of the underlying stock, then writing cash-secured put options is an acceptable strategy. NOTE: Most option traders are not interested in buying stock because they are trading for short-term gains. However, if you are an investor, this is a viable strategy.

Risk Management

Let's look at two different trades, each of which generates a cash premium by selling call options:

Stock WXY is $42 per share and you feel strongly that the stock is over-priced. You want to earn money if and when the stock price declines.

Let's assume that you do not want to sell the shares short because the margin requirement is too high. That leaves you with the two bearish strategies: buy puts or sell calls. The premise for this article is that you prefer to sell, and not buy options and therefore you do not consider buying puts.

The naked call. Assume that expiration is 60 days in the future. The trade:

            Sell 2 WXY Mar 17 '17 45 calls @ $1.10 

If you are not familiar with option symbology, the above trade represents the sale of two call options on WXY stock. The options expire on March 17, 2017 and the strike price is $45 per share. You collected $110 per option (and that is yours to keep -- no matter what happens).

By making this sale, you agreed to sell 200 shares of WXY at $45 (the strike price) at any time before the options expire. NOTE: You cannot demand that the option owner buys the stock at that price. The option owner has the right to buy your shares; but he/she has no obligation to do so. You have nothing to say about that decision.

If you do not already own 200 shares, then the calls are naked, or unhedged.

This seems to be a trade without a lot of risk. After all, the stock has to climb by 3 points before the option moves into the money, and you don't believe the stock price can move that far. The problem is that most traders cannot predict market direction correctly on a consistent basis. And even when they have that skill, unexpected events can make their predictions moot. 

If Google (or any other company) decides to acquire WXY and bids $55 for all outstanding shares, then your innocent-looking option sale has become costly.

When the news of the takeover is announced, WXY could jump from $42 to $57 per share. Why is it trading higher than the announced takeover price? Because the stock is now "in play" and the market believes that some other suitor may come along and outbid Google. Or perhaps the general feeling is that Google will have to up its bid to finalize the deal. Regardless, your position has lost more money than you can afford to lose and fearing that things may get worse, you decide to exit the trade. 

You buy those calls, paying $13 (that's $1,300 each) for a net loss of $2,380. That sum may not represent a gigantic cash loss, but when the maximum profit was only $220, most traders would consider that to be an unacceptably large loss. 

Note: The takeover risk is small. But there is always market risk where the stock price rallies to $50.

The point is that the potential loss is not known because there is no theoretical upper limit.

The naked put. This time, let's assume that you are quite bullish on the same stock and believing that the price cannot go much lower, you decide to make this trade:

            Sell 2 WXY Mar 18 '16 40 puts @ $1.50

You collect $300. This time the company runs into an unexpected problem (a competitor has introduced a revolutionary product to the marketplace) and the market price of WXY gaps lower on the news. With the stock trading at $34 per share, and with the market fearing a further decline, numerous investors want to buy (with few willing to sell) puts, so the options become highly valued. It costs $8.50 ($1,700 to cover the two puts sold earlier, for a loss of $1,400).[See this article on how to trade when implied volatility soars.]

Although this loss may be too larger for a trader, it is possible that the person who wants to buy stock would be satisfied to hold onto the position.

The credit spread. Instead of just selling the call or put options (per the above examples, let's see what happens when you buy one option for each option sold. That converts each trade into a credit spread.

            The call trade:
            Sell 2 WXY Mar 18 '16 45 calls @ $1.10
            Buy 2 WXY Mar 18 '16 50 calls @ $0.40
            Net credit is $0.70 per spread, or $140 total.

            The put trade:
            Sell  2 WXY Mar 18 '16 40 puts @ $1.50
            Buy 2 WXY Mar 18 '16 35 puts @ $0.45
            Net credit is $1.05 per spread, or $210 total.

Many traders don't want to own these positions for two basic reasons:

  1. If they don't think that the stock is going to move as high (low) as $45 ($40), then why should they buy calls (puts) with a strike price equal to $50 ($35)? That's a waste of money!
     
  2. The potential profit is significantly reduced when they trade the spread vs. the single option. The credit on the call trade is reduced by $0.40 (36%) while the put credit declines from $1.50 to $1.05 (30%). Not only that, but there are extra commissions to pay when buying those "unnecessary" options. 

That way of thinking (mindset) is difficult to overcome. However, it is a losing mindset and must be overcome when you want to manage risk. In my opinion, traders who do not understand the importance of risk management have little, or no, chance to find long-term success as a trader.

To understand why buying those "unnecessary" options is a sound trading practice, let's compare the sale of the naked option with the sale of the credit spread.

Calls: The naked sale lost $2,380 in our example. True, this was an unlucky result and will not occur often, but smaller losses due to a surprise rally in the stock price can, and will, occur. When trading the spread, the short March 45 call option is hedged because you own the Mar 50 call. No matter how high the stock price may rise, your loss is limited (capped). Your long option gives you the right to buy shares at $50 while your short call gives you the obligation to sell shares at $45. Thus, closing the position never costs more than that $500 difference in the buy and sell prices (i.e., the difference in the strike price multiplied by $100). In this example, that maximum loss is $500 per spread -- minus the $70 premium collected. Therefore, 2 * $430 = the maximum possible loss, or $860.

Is it worth buying the cheaper call or put option to reduce the maximum possible loss from a potentially big number to $430 for the call (or $395 for the put) spread? Answer: It is. Most of the time you would have been better off not buying that extra option as protection. However consider this: you regularly buy insurance on your car and home, despite the fact that it goes unused most of the time. You probably cannot afford to lose the entire value of your home, so you buy insurance. Owning the spread gives you the peace of mind that comes with insurance -- and avoiding large losses increases your chance of being a long-term winner at the trading game.