Tag Archives | negative gamma

As expiration nears, how does theta behave?

Mark,

I am currently on my second round reviewing the greeks, and this time I am going into more depth. As I am putting together my notes I found references that describe time decay for both OTM and ATM positions. To my surprise, the shape of the graphs is different.

The graph that we are all accustomed to seeing shows that time decay accelerates as expiration nears. Most of the theta decay occurs in the last 30 days in which theta is increasing as the remaining time value of the option is decreasing.

Time_value_of_an_option__standard

When it comes to OTM options, according to the authors, the shape changes significantly. In the last 30 days, decay decelerates and the majority of the decay occurs before the last 30 days. This is the graph of an OTM option and its time decay.

Time_value_OTM_options_

I have been looking at various option series for both stocks and ETFs and I have not been able to confirm this.

Question.

If the above statement is true, when trading iron condors, why wouldn't you pick a timeframe for opening the position near 60 days to expiration and probably closing ~30 days before expiration? This would allow the trader to capture a larger portion of the time decay – because OTM positions make up the iron condor.

JG

***

This is a very thoughtful question and illustrates why spending time trying to understand the things we are taught is such a good idea.  Thank you.

The general view regarding time decay is correct.  Theta accelerates as expiration approaches.  However, we must recognize that some siturations are different.  Let's say that a stock is trading near 79, there's a week left prior to expiration, and the option under consideration is the 80 call.  Surely that option has time value and with that comes time decay – and the option loses value every day.  Just as you anticipate.

However, consider the call option with a 50 strike.  Unless this stock trades with an extreme volatility, the call has already lost all time value (except for a component due to interest rates) and trades with a bid that is below parity. 

Or you can look at the corresponding put (which has the same theta) and see that it doesn't trade and the bid is zero. It has already lost every penny of it's time value.  Its theta is zero.

These are the situations to which your references are referring when stating that time decay decellerates into expiration.  When options move to zero delta and 100 delta, the time decays disappears prior to expiration.

Most traders who are talking about options and their time decay, are not interested in such options (there is nothing of interest for a trader to discuss).  Thus, options such s the 80 call mentioned above (and the corresponding 80 put) have time value, accelerating time decay and an increasing positive gamma.  These options decay according to your first, or 'standard' graph.

FOTM options

There is more to the rate of time decay than the time remaining.  When options are far OTM or deep ITM, things are just different.  Once you understand that situation (as I'm certain you do now), the theta problem goes away. Once an option has only a small time premium remaining, it cannot keep losing value at the same rate – or else it would become worth less than zero.

Iron Condors

Time decay is what makes trading iron condors profitable. Sure it may be good to own the position when time decay is most rapid, but that is not the 60 to 30-day iron condors that you envision.  That would work only when the calls and puts are both quite far OTM.  That means a tiny premium to start the trade.  That's a non-starter for me.

In the real world of condor trading, most options are not that far OTM and have enough time premium to belong in the standard decay group.  When markets behave for premium sellers, the last 30 days are the periods with the most rapid time decay.  For most iron condor traders, that is the ideal situation. However, that's also the period of highest risk – due to negative gamma.  For me, collecting the fastest time decay is not as important as owning a less risky trade.

863

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What Other Bloggers are Saying

 

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Oct 12, 2010;  5 PM (ET)

 


I've often mentioned that I avoid trading near-term options, especially as expiration draws near.  My primary reason:  Negative gamma increases, and that's more risk than I want to accept.

If you are interested in a bit more detail as to why this phenomenon occurs, Jared at CondorOptions and Steven at Investing With Options recently disucssed how time to expiration affects delta (charm) and gamma (color).

If those terms: charm and color are unfamiliar, Wikipedia offers definitions for readers who want a more mathematical description.  Charm and color are among the less well-known Greeks.  They are not Greek letters, but are considered to be options "Greeks."

Charm or delta decay, measures the instantaneous rate of change of delta over the passage of time.  Charm can be an important Greek to measure/monitor when delta-hedging a position over a weekend. Charm is a second-order derivative of the option value, once to price and once to time. It is also then the (negative) derivative of theta with respect to the underlying's price.

Color or gamma decay  measures the rate of change of gamma over the passage of time. Color is a third-order derivative of the option value, twice to underlying asset price and once to time. Color can be an important sensitivity to monitor when maintaining a gamma-hedged portfolio as it can help the trader to anticipate the effectiveness of the hedge as time passes.

***

Jared concludes: "Delta decay is of particular interest to traders holding ATM or OTM options near expiration, especially when those options are serving as portfolio hedges."

Steve puts it this way: "So we know that gamma increases in magnitude over time. This is known as charm. So if you are selling puts with 5 weeks left, you will have less overall “heartburn” than if you sell puts with 5 days left. The tradeoff is less theta, but that’s for another post."

 

For more detail refer to these posts.  I understand that this is the Options for Rookies blog.  If the idea of charm and color feel too advanced, all you really have to know is that gamma increases as expiration approaches, and that holding short option positions into expiration comes with extra risk.  I know you have heard that idea before.

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Gamma, Vega and Risk Management

When trading options, holding positions with too much gamma – positive or negative – can be dangerous. It's necessary to avoid getting hurt by the two most destructive emotions for traders: fear and greed.

On Monday, Jun 28, 2010 the markets fell hard.  That 1040 SPX price level – that many believe is a vital support area – was tested.  Option prices rose sharply as is seen in the performance of VIX and RVX.

Tuesday (as I write this) the markets are slightly higher and option prices are once more coming down to earth.  I had better rephrase that.  Option prices and implied volatility are decreasing, giving up a significant portion of yesterday's gains.  In my opinion, prices are still high.  ADDENDUM: By the end of the day, the markets closed lower.  SPX broke down by trading below 1030.

When IV moves sharply higher, the trader who is not vega neutral, and that includes most of us, must demonstrate the ability to handle and manage risk.  If you are a clear thinker and make good trading decisions, your portfolio is probably in good shape.  The same can be said for most traders who prepared a trading plan in advance.  That plan is designed to save any trader (and especially the inexperienced) from panicking in a stressful situation.


Positive gamma and vega

As the markets get more volatile, and especially as markets decline, traders who own positive gamma and positive vega are well positioned to profit.  Nevertheless, that trader cannot afford to idly watch the markets as the days pass and theta takes its toll. 

Positive gamma is a delight in that it allows the trader to pick the time and place for making an adjustment.  This adjustment locks in profits and can include the sale of some options to reduce both gamma and vega, or it can be made in the form of shares of the underlying (stock or futures contracts).  It's tempting to hold the position, but a minor reversal, such as seen Tuesday morning threatens much of the profits.  Greed makes the trader hold out for larger gains.  Fear makes the trader panic and sell (what is probably) an inappropriate portion of the position.

However, a well-thought out plan, or sound risk management, allows the trader to reduce risk by moving closer to neutral in gamma, vega, and delta.  Ignoring greed, the successful trader adjusts the position – retaining some vega and gamma.

Negative gamma and vega

Iron condor traders seldom find themselves in the positive gamma/vega boat.  The only exception occurs when extra options are owned as insurance, and these extra options are in play (not too far away from being ATM).

Thus, they (we) may be floundering when the positive gamma group is sailing along smoothly in those choppy waters.

If your positions have too much negative gamma, if your short options are not too far OTM, then it's time (or past time for many conservative traders) to adjust the position.  Panicking in a sudden meltdown is unlike to produce good results.  However, ignoring problems, hoping they will disappear, represents a different type of panic decision – being too afraid to act.

If you have a trade plan in place, it's probably right to take the action as prescribed in the plan.  Lacking a plan, it's not too late to create one now.  If you are capable of making sound decisions as losses mount, then good for you.  Take advantage of that skill by taking sound steps to protect your assets.  Be aware of potential loss, your pain threshold and comfort zone boundaries.

If you lock in a loss and the market reverses, so be it.  Your goal is to pay attention to rule #1: Don't go broke.

If you are not yet in trouble on this decline, you have the luxury to plan ahead.  I'm planning to sell extra vega by doing a ratio roll down* for some RUT Aug and/or September put spreads.

* Close current short put spread and sell a larger quantity – perhaps 3 for every 2 bought – of farther OTM put spreads.  I prefer to move the strike of the short option by at least 3 strikes.  Collect a small cash credit for the trade.  I only do this when my portfolio is not already at its maximum size.  Make no mistake about this trade: it does increase ultimate risk.  it looks good because the probability of the large loss is reduced.

Example buy two 560/550 put spreads and sell three 500/510 (or perhaps 510/520) put spreads.

730

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Options Expiration. Six Things to Know, Before you Play the Game

Over at the Options Zone, this post (slightly edited) was published on April 14, 2010.


OptionsZone_logo

Options expiration.  When you sell options, it's an anticipated event.  When you own options, it's something to dread.

At least that's how most people view it.  There's much more to an options expiration, and if you are a newcomer to the options world, there are things you must know and steps you should take to avoid unpleasant surprises.  However, if you enjoy nightmares, feel free to disregard this entire post.

Many investors come to the options world with little investing background.  they consider the 'options game' to be simple:  You buy a mini-lottery ticket.  Then you win or you don't.  I have to admit – that's pretty simple.  It's also a quick path to losing your entire investment account.

It's important to have a fundamental understanding of how options work before venturing onto the field of play.  But not everyone cares.  It you are someone who prefers to keep his/her money, and perhaps earn more, then those option basics are a must for you.

No one takes a car onto the highway the
very first time they get behind the wheel, but there is something about
options, and investing in general, that makes people believe it's a
simple game.  They become eager to play despite lack of training.

Today's post provides some pointers for handling an options expiration.  Options have a limited lifetime and the expiration date is always known when options are bought and sold.  For our purposes assume that options expire shortly after the close of trading on the 3rd Friday of every month. (Expiration is the following morning, but that's just a technicality as far as we are concerned)

***

Please don't get caught in any of these expiration traps.

1) Avoid a margin call 

New traders, especially those with small accounts, like the idea of buying options.  The problem is that they often don't understand the rules of the game, and 'forget' to sell those options prior to expiration. If a trader owns 5 Apr 40 calls, makes no effort to sell them, and decides to allow the options to expire worthless, that's fine.  No problem.  However, if the investor is not paying attention and the stock closes at $40.02 on expiration Friday, that trader is going to own 500 shares of stock.  The options are automatically exercised (unless you specifically tell your broker not to exercise) whenever the option is in the money by one penny or more, when the market closes on that Friday.

In my opinion, this automatic exercise 'rule' is just another method that brokers use to trap their customers into paying unnecessary commissions and fees.

On Monday morning, along with those shares comes the margin call.  Those small account holders did not know they were going to be buying stock, don't have enough cash to pay for the stock – even with 50% margin – and are forced to sell the stock.  Rack up more costs for the investor and more profits for the broker.  Please don't forget to sell (at least enter an order to sell) any options you own. 


2) Don't exercise

If you own any options, don't even consider
exercising.  You may not have the margin call problem described above, but did you buy options to make a profit if the stock moved higher?  Or did you buy call options so that you could own stock at a later date?  Unless you are adopting a stock and option strategy (such as writing covered calls), when you buy options, it's generally most efficient to avoid stock ownership.  Here's why.

If you really want to own stock, when buying options you must plan in advance, or you will be throwing money into the trash.  For most individual investors – at least inexperienced investors – buying options is not the best way to attain ownership of the shares.

If the stock prices moves higher by enough to offset the premium you paid to own the option, you have a profit.  But, regardless of whether your investment has paid off, it seldom pays for anyone to buy options with the intention of owning shares at a later date.  Sure there are exceptions, but in general: Don't exercise options.  Sell those options when you no longer want to own them.

Example: Here's the fallacy.  The stock is 38, you buy 10 calls struck at 40, paying $0.50 apiece.  Sure enough you are right.  The stock rallies to 42 by the time expiration arrives.  You know a bargain when you see one, and exercise the calls, in effect paying $40.50 per share when the stock is worth $42.  This appears to be a good trade.  You earned $150 per option, or $1,500.

Before you congratulate yourself on making such a good trade, consider this: The truth is that you should have bought stock, paying $38.  If you are of the mindset that owning shares is what you want to do, then buying options is not for you.  And that's even more true when buying OTM options.

If you are an option trader, then trade options.  When expiration arrives (or sooner) sell those calls and take your profit (or loss).  There's nothing to be gained by exercising call options to buy stock.  Why pay cash for an option, then hope the stock rises so that you can pay a higher price for stock?  Just buy stock now.  If you lack the cash, but will have it later, that's the single exception to this rule.

If this exception applies to you and you are investor, not a trader, then buying the Apr 40 calls is still the wrong approach.   Buy in the money calls – perhaps the Apr 35s.  You might pay $3.60 for those calls.  If you do eventually take possession of the shares, the cost becomes $38.60 (the $35 strike price plus the $3.60 premium) and not $40.50.  Buying OTM options is not for the investor.

to be continued…

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Trading Options Near Expiration

This post was recently published at Options Zone, with the clever title: How
to Avoid the Wrath of Gamma at Expiration
.


When it comes to trading near expiration, there are almost as many opinions about what to do as there are traders.  I'm a strong believer that it's best to avoid holding any positions into expiration, but that's especially true for short positions.

The rapid time decay and the thrill that comes with watching options (that you sold) expire worthless, makes it very tempting to hold onto short positions.  Part of the time it just feels like a waste of money to pay $15 to $25 for an option that is 'obviously' going to be worthless next week.

More than that, when an option is out of the money by a small amount – perhaps 2%, it's tempting to look at that wonderful ticking clock and count how much you are making every hour.  Ah yes, beautiful theta is a joy forever.

Alas, options with positive theta come with negative gamma.  For the option short, you can describe theta and gamma:  "It was the best of Greeks; it was the worst of Greeks."

Nothing results in larger accelerating losses than owning positions with negative gamma.  Watching the stock race from being out of the money to moving into the money can be a paralyzing experience.  We all 'know' that this cannot happen to us and that each of us would simply buy back the options before it became a problem.  If you've never been there, if you've never watched an option move from $0.25 to $1.00 in a heartbeat, then you just don't get the situation.  

If you didn't want to pay a quarter, how in the world are you going to convince yourself to pay a buck?  And while you are trying to pull the trigger, the option is now priced at $1.25 and then $2.  Stubborn now, there's no chance you will decide to pay that 'outrageous' price.  Convincing yourself that someone is manipulating the stock price as expiration approaches, you do nothing.

Sometimes this stubbornness is rewarded, and the stock stops its movement and retreats.  Perhaps a rumor drove it higher and the denial is lowering the stock price.  The problem with being rewarded in this situation is that no lesson is learned and next time you may not be so lucky.

At other times, this is just the beginning.  The next morning the stock opens higher and keeps on moving.  At some point the pain is too great and you cover.  Is that $4 per option, $6? Who knows.  But it doesn't matter.

What does matter is that you were so in love with positive theta that you ignored its partner, negative gamma.  That particular Greek does not like to be ignored, and every so often gamma rears its head and takes no prisoners.

In my opinion, the risk of holding short options into expiration far outweighs any potential rewards.


The Other Side

Of course, there's another side to the story.  Jeffrey Augen wrote an entire book based on the idea of teaching his readers how to Trade Options at Expiration.

 
Augen book

Trading Options at Expiration: Strategies and Models for Winning the Endgame

For the right trader, these methods are worthwhile.

One thing is certain, whether you buy or sell options, trading near expiration can be exciting or frightening – or both.

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