Options Trading: How to Determine the Best Options to Sell
11/29/2017 10:32 am EST
The interplay of delta, theta, and time to expiration all play a role when selling credit spread and Iron Condor options, writes Amir Atabaki, chief publisher of the Time Decay Options Advisory Service at Monthly Cash Thru Options, an options advisory newsletter and educational service.
(Sponsor content) Credit spreads and iron condors are popular options trading strategies. Many investors like how these option-selling, non-directional strategies offer high probabilities of success, many times near 90%, while generating monthly income.
When determining the best options to sell when trading credit spreads, it’s important to understand the basics of how delta, theta and time to expiration play a role.
The first Greek to define is delta. Delta represents the dollar value an option will move with an underlying $1 move in the stock or index. Delta also represents the probability an option will expire worthless. For instance, if an option has a delta of .20 this would signify a 20% chance that the option will expire in the money (ITM) or an 80% chance the option will expire out of the money (OTM).
For sellers of options in the form of credit spreads most traders are interested in selling options with a high probability of expiring OTM and worthless.
Theta represents the rate at which the value of an option will depreciate as expiration arrives. Moreover, an option’s theta or time decay will accelerate as it approaches expiration. We will examine options over three time periods to show the effect that delta and theta have when selecting an option to sell.
The delta that we have chosen to examine is a delta of .15 for a call option on the S&P 500 Index (SPX), or whichever is closest to that number over 15, 31, and 46 days to expiration. All of these options are out of the money. We will illustrate the effect that time has on distance from the underlying that one can achieve over these time frames. We analyzed these options on 11/14/16 with the SPX trading at 2160 and CBOE Volatility Index (VIX) trading around 15.
The first option we look at expires on 11/28 or 14 days out. The option closest to a delta of .15 is the 2205 call option (delta of .14) with a trading midpoint of $2.67. As you can see with 14 days until expiration the option is 45 points away from where the SXP is trading, or 2.08% away. The theta for this option is -.29 and represents the daily rate of decay for this option.
Next, we look at options expiring on 12/16 or 31 days until expiration. An option with a delta of .15 for this expiration is the 2230 call option and its trading midpoint is $5.25. The option is 70 points away from the underlying, or 3.24%. The theta for this option is -.25.
Lastly, we look at the 12/30 expiration that is 46 days until expiration. An option with a delta of .15 for this time frame is the 2245 call option and its midpoint value is $6.10. This option is 85 points away from the underlying, or 3.93%. The theta for this option is -.20.
There are three dynamics that are illustrated when looking at options with the same probabilities over differing time frames.
First, as mentioned above, theta represents the rate at which the value of an option will depreciate as expiration arrives. Moreover, an option’s theta or time decay will accelerate as it approaches expiration. We can see that Theta for the Delta .15 option that expires on 11/28 is -.29. This value for theta tells us that the value of the option will depreciate by 29 cents each day that passes.
For the delta .15 option that expires on 12/30 we can see that theta is less at -.20. Because the 12/30 options have more time before expiration, the daily rate of depreciation is less. Thus, we can see that as time elapses time decay has the greatest impact on the options that are closest to expiration.
The second dynamic is the further out in the calendar one goes the more expensive an option will become. This is because you are paying more for time premium the further you go out in time, known as the extrinsic value of an option. All of these options are currently out of the money and hence any price that you pay for said options represent its extrinsic value as they have no inherent “real” value other than time. The more time to expiration that you sell the further you are able to move away from the underlying stock or index.
The third dynamic is that options that have more time to expiration are more easily adjusted. Periodically, an option that is sold will come under pressure by the underlying stock or index and it’s imperative to adjust and roll the trade into a new strike price and out further in time to keep the sold option from going ITM.
Credit spread adjustment methodologies are outside the scope of this article and for more information about how to adjust credit spreads please visit Monthly Cash Thru Options or contact us.
How one determines which option or spread to sell will be based on desired risk appetite and current thesis: bearish, bullish, or sideways. If you choose to sell the option that has 16 days until expiration the strike price of the option will be closest to the underlying (2.08%), but will also enjoy less exposure to time and have the fastest rate of time decay.
The option that has 46 days until expiration provides the largest cushion from the underlying stock or index (3.93%), but has the most exposure to time and the slowest rate of time decay.
The option that has 31 days until expiration offers a mix of both distance from the underlying (3.24%), time exposure, and time decay.
Each option has its pros and cons and is a sliding scale of risk/reward. The shorter-dated options provide a margin for error in that time is working in your favor with each passing day, even if the market is moving against your position, as long as it remains out of the money.
The further out in time that you sell an option, the less time and time decay work in your favor, but it provides the most distance between your option’s strike price and the underlying stock or index. Moreover, the longer time frames allow a trader to more easily adjust a position that has come under pressure.
We can see that delta, theta, and time to expiration can be used as a guide to help one select the most appropriate option to sell. The selected option strike price and time to expiration will depend on a trader’s risk tolerance and desired distance from the underlying.
About the author and Monthly Cash Thru Options LLC: Amir Atabaki is chief publisher of the Time Decay Options Advisory Service at MCTO. MCTO is an options trading advisory & investment services firm that offers three options-based trading services and two newsletters.
Two of the autotraded strategies are non-directional and use index credit spreads and iron condors. The third autotraded strategy is a long/short directional service that buys calls and puts on stocks to take advantage of short-term moves.