Tag Archives | theta

Adjusting a position: Using the underlying


I have maybe a naive question. Is it possible to make adjustments to already open positions, that might be 'in danger' of losing money, using stocks (or indexes if applicable) instead of options?

From "The Rookie's Guide to Options" I know that it is possible to create 'synthetic' positions and sometimes it makes sense to trade them.

One example: A put spread where short side is ATM (or very little out), probably too late, but at this point the put should be bought back.  Instead one might short the stock and buy a call to protect from a big upside move.

Could you please explain what are pros and cons of such adjustments.



Good question.  Let me reply by making some points

1) Yes, you can use stocks or futures or any underlying asset for adjustments.  Remember that these adjustments provide only delta (positive or negative), and do not reduce gamma, vega, or theta risk

2) Any trade that reduces risk and leaves the trader feeling comfortable with the adjusted position – is a satisfactory adjustment.  That is one of the goals of risk management.

3) Buying or selling shares is a very appealing adjustment method, but in my opinion, it's a poor idea.  Many traders use stock as their adjustment of choice, believing that 'fixing' delta is all that is needed to make a satisfactory adjustment.

Think about why the position is in trouble in the first place.  The ATM put contributes significant negative gamma to the position.  Buying, or in your example, selling, stock does nothing to reduce that gamma risk.  It does take the immediate delta risk out of play.  And that's good enough for some traders.

The advantage of using stock is that the trader doesn't have to pay for any gamma and does not have to sacrifice any theta (time decay).  After all, thinks the trader, I'm in this position to collect theta, so why would I want to make a trade that cuts my positive theta?

Answer: Because buying gamma comes with negative theta. And reducing both delta and gamma is going to make the position safer than only reducing delta.  If you – an individual decision – are comfortable with maintaining the negative gamma position, then by all means – adjust with stock.  However, I feel more comfortable reducing delta and gamma risk, rather than delta only.  There's no right or wrong here.  It's a personal choice.

There is also risk of getting whipsawed.  Although that possibility exists with any adjustment, it is especially painful when the adjustment was made with stock becasue it results in a buy high, sell low scenario.

My recommendation is that it's okay to adjust with stock when you cannot figure out what else to do – but the adjustment should be temporary.  As soon as you have the chance to unload the stock position and replace it with a positive gamma trade, that will give you a better position.  'Better' from the perspective of less risk in the future.

4) Consider your example.  You are long delta because of a short put spread.  Apparently you don't want to buy any puts, but you are considering selling stock short and buying calls to protect the upside.

Ask yourself: Why don't you want to buy puts?  Is it that if you buy the put you sold earlier that you would be locking in a loss?  Is it that puts seem to be too costly?  Is it that you hate paying the time decay present in the puts?  Is it that it feels more 'professional' to make an adjustment, rather than closing the position?

None of those is reasonable.

When you short stock and buy calls to protect the upside, you are buying synthetic puts.  Stock plus a call is the same as owing a put at the same strike as the call.  If you make the suggested trade, you are complicating a position (and raising margin requirements) for no good reason.  Buying the synthetic put is the same as buying the 'real put' – and if determined to make the stock plus call play, then I strongly recommend buying the appropriate put instead.

To answer, I cannot think of a single 'pro' for making that play , only 'cons'- unless the prices of the options are so far out of line that buying stock plus puts is a lot cheaper than buying the call (do not forget that it costs money to own stock).  The 'cons' have it.

Robert – just because you can trade a synthetic (or equivalent) position, it does not follow that it's always a good idea.  Here, buying protection in the form of puts makes the most sense (unless exiting makes you feel better).  As an aside:  DO NOT refuse to exit this trade to avoid locking in a loss.  If this position no longer feels right to hold, then please don't hold it.  On the other hand, if you like the adjusted trade and want it as part of your portfolio, then adjusting is the better choice.


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As expiration nears, how does theta behave?


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.


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.


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


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.



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.



Peace on Earth.  Liberty for all.  Best wishes for 2011



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Establishing Trading Rules: How Much Experience is Needed?


Based on what I learned and thought about over the past few days due to my

  • I would now only buy calls/puts in the front month. The
    odds are more with us [MDW: Us? How did I get involved?]  because of gamma. Is this thinking correct?
  • The
    loss is limited to premium paid, but the upside is huge

  • I would
    never buy otherwise because theta is the enemy

  • I am not sure what I
    would buy though, ATM or 2 levels OTM.


Slightly off-topic: Based on looking at my trades, time decay is not
linear. The more the underlying is at a particular strike, the more the
time decay at that strike.

Is the time decay calculated per day or week
to week?

The time decay graphs given in most literature gloss
over the fact that those decay graphs are concerned with an option which stays
exactly ATM all the time. Why?  The real spot price gyrates?




I get it.  You are an eager student.  You want to trade options right now and make money today.  Every time you see a piece of evidence about a specific strategy, you believe you found the Holy Grail.  I can only tell you that you are making a huge mistake.

You are FAR TOO INEXPERIENCED to make these decisions.

This is learning time.  This is experiment time. 

You cannot make a few trades and reach a permanent-sounding decision such as: 'I would only buy front-month options.'  If you reached this decision, on what is the thought process based?  How many times have you traded 2nd or 3rd month options?  How did the results compare?  Did you make good money by correctly predicting direction, or did something else happen that made the trades profitable.

It is wrong to assume that a profitable trade means you are a genius. 

It is wrong to assume that a losing trade is the result of a mistake.

You must compare the trade with others and discover why the trade was profitable (or not).  The 'why' is how you learn.

NOW is your chance to trade a variety of ideas, analyze the results, keep detailed records, think about the results and make an attempt to get a feel for what works and where to establish risk limits you can handle.

1) No the odds are not with you because of gamma.  The odds are not with you, period.  You have much less time to be right in your prediction.  If it does not happen soon, time decay will eat away at the value of your options.

How can the odds ever be with you when you must predict the direction of the move, the timing of the move, the size of the move?  You must be a very skilled market timer with a PROVEN track record before you can have any expectation of making money when buying options.

I'd hate to see your enthusiasm disappear down a sink hole.  Didn't you try this 'buying options' strategy once before?

2) Yes the Reward to risk ratio is excellent.  But the probability of success is not.

3) I don't understand the 3rd point.  When you buy front-month options, theta is the big enemy.

4) This is your problem in a nutshell.  You want to buy. You think buying and owning positive gamma puts the odds of success on your side.  But you give no consideration to how far the stock must move.  You don't know which options to buy.

It doesn't work that way.  The whole strategy requires knowing which options to buy, or having a method for deciding.  It's not a random selection.  It you cannot estimate the size of the move you should not be buying options.

Buying out of the money options is very much a gamble.  Some players succeed. I have no idea where your talents lie, but if you are excellent (proven track record), you can win this game.  Otherwise, not a chance.  Especially when you buy OTM options.

Off topic:  Time decay is NOT linear.  ATM options have the most time premium and thus, the most rapid time decay.  Time decay of American style options is based on the amount of time remaining until the market closes for trading on expiration Friday. 

The decay can be determined for one week, one day, one second, or any other time period you care to mention.  However, the Greek theta measures the time decay for one day.  Theta tells you how much value the options loses overnight.

Most option analytical tools that measure something specific, such as theta, assume all else is constant.  It MUST be this way.  If you want to know about theta, then if anything is not constant, that item will also affect the option price, and you will NOT be able to tell what part of the option price change is due to theta.  Please tell me that you understand this is true.

One of my basic tenets is that it is very foolish to trade when you don't understand the rules.  Some rules (automatic exercise) can come as quite a surprise to the novice. Other properties of options (how quickly they decay as expiration nears; or the sale of options is not free money) may not be immediately obvious.  But it makes no sense to use tools  when you don't know how to use them.

What's your hurry?  You have the rest of your life to trade. 

Practice in a paper-trading account or trade small size in your real account.  But don't go jumping to conclusions based on one or two trades.


July 2010 Expiring Monthly.  Table of Contents:


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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.


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Lessons of a Lifetime: My 33 Years as an Option Trader;  $10


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How Much do I Lose on a 5% Market Decline?

Here's a very simple question from a reader.  And to be honest it's an excellent question and it's something I have never specifically addressed.  I've told readers to do it, but without details.


Just read your post and would like your help on how to most accurately determine how much a portfolio will lose from say a 5% fall?

Underlying:  RUT. 

Here are the Greeks: -50 delta, -5 gamma, +300 Theta, -800 vega.
Thanks for your help,



That's a lot of vega!  You did not supply enough information, so I'll make assumptions.  I need the current IV (so we can estimate the new IV, post decline).  I'll use RVX, which is near 35.

Most accurately?  That's a tough one.  You must have a very good estimate of how much IV is going to increase, especially when your vega risk is substantial.  That is difficult all by itself.

A) I would use software – hopefully provided by your broker – that plots positions on a graph.  Look at the position with RUT down 32 points to 614.  Then increase IV by ?? Try 10 and 20% as guesses. Change the date to one day later.

If such software is unavailable to you – consider opening an account at TOS.  No need to fund it.  That should allow you to use their excellent software.

B) Lacking good software, then your next best answer is to break down your position into it's individual option components.  I understand that you may have so many different option series that this is going to be too time consuming.  However, if you own just one or two different positions, then it's probably worth the time to do it.  Find an options calculator.

For each single option in your portfolio, determine the option's value at today's price and tomorrow's price.  For tomorrow's price, use the 5% decline number and once again make a guess as to the future IV.  There is no way around that.  We don't know of there will be panic or relative calm in the marketplace.

Multiply each option by the quantity in your portfolio and determine how much is lost.  It's a good idea to record the new Greeks to help make a similar estimate in the future.  By that I mean it's good to know how gamma, vega change and theta change.

C) If you are willing to accept a less accurate method, then we have to do a 'quick and dirty' calculation – and that's the basis for this post.

1) Gamma.  We don't know the rate at which gamma changes, so let's guess. Gamma is now -5 and will be -10 after the 5% decline.  I admit this is just a guess.  Thus, we have a 32 point decline with an average gamma of -7.5.

2) Delta is -50 and will (negatively) increase by 32 * 7.5.  New delta: -290.

Average delta over the decline: -170 (avg 50 and 290).

32 * 170 = $5,440.   This is the loss from delta

3) Theta.  You get your $300, but theta is almost certain to be higher tomorrow.

4) Vega.  Assuming vega remains near 800, and assuming that IV increases by 10%.  That's an increase of 3.5 points or a loss of 3.5 * 800 = $2,800

Simon, please remember that each of these Greeks is changing.  Just as gamma changes delta, so to do gamma and vega and theta change as the underlying price changes.  Thus,these are merely good guesses.  They work as a ballpark figure.  they allow you to decide whether this risk is too large for you to accept.

Here's where it gets tricky. 

a) The problem is that if panic were to set in, then IV could double to 70.  If that happened, the estimated loss – just from vega alone – would be $800 * 35, or $28,000.  If you were to incur that loss – and if you did not have an margin call and were allowed to continue to hold the position – the question is would you do so.

NOTE: If using Reg T margin and if your positions are protected (i.e., no naked short options), then you will not get a margin call.

b) There is a limit to possible losses.  If you own (for example) 20 iron condors, then it's impossible for the loss to exceed $20,000 minus today's position value.  And I'm sure you understand it would never get that high. 

If the markets were very wide, then your position could get 'strange' closing marks, but I do not believe it's possible for your account to be placed in jeopardy.  But this is a question for your broker, not for me. [What happens if my 10-point iron condor is market a 15 points?  Could I be forced to liquidate?]

Markets can be very wide, but when options are being quoted, the is every reason to believe that it will be impossible to collect >$10 for a 10-point iron condor and I assume that means your end-of-day marks must be in the rational range.  Thus, I assume liquidation is something we can all safely ignore.  But, it is an assumption.

c) If the market does drop that far and if IV does rise that much, I cannot imagine that your loss to vega could be that high.  It fact, at that level, your portfolio could easily be short far less vega.  In fact, when your LONG options are closer to being ATM that the shorts, you will be positive vega.  So the vega estimate is fraught with potential inaccuracies.  That's why the risk graph works so much better than anything else – for your needs.


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