Premium and Time Decay
By: Todd Horwitz
The following is an excerpt from Todd "Bubba" Horwitz’s Bubba’s Guide to Trading Options
Short Premium with Positive Time Decay
Here we know that when we sell an option that our reward is limited and risk can be unlimited. As an example, let’s suppose that we are trading in a scenario where the VIX is below its 200 day moving average and we are short premium.
If we are bullish, the most aggressive trade is to sell a naked put. If you are bearish, you could sell a naked call. When you write a naked option, you have a reward limited to your credit, but your risk is UNLIMITED!
If we are bullish we can, 1) Sell the vertical put spread – Bull Put Spread, or 2) Sell the first OTM strike, to the upside, straddle.
If we are bearish we can, 1) Sell the vertical call spread – Bear Call Spread, or 2) Sell the OTM strike, to the downside, straddle.
Three things can go wrong:
- The market breaks out to the downside/upside, which will be the opposite side of our winning trade.
- The market rallies/breaks as expected, but is accompanied by very high volatility.
- The market gets in tight congestion, but volatility explodes.
Each situation is handled the same in terms of risk management. In each situation you are short premium. When you sell a spread you have a reward limited to your credit. You risk is limited to the spread between the strikes, minus your credit.
Case One: If the market price goes immediately to the opposite side of our trade we will use the same rules as if we were long premium. In this case however, it is the opposite of selling our loser’s if they lost 30% of their premium. When we are short premium, we will buy the credit back if it gains 30%. This is not the same thing as allowing the stock to move by 30%. The ATM option or vertical should never represent more than 10% of the underlying stock, so that when we allow the premium to grow 30%, it is the same as taking less than an approximate 3% stop loss on the underlying stock. When we are short premium a straddle is still considered double premium and we take our loss at an increase of 30% of the value of the straddle.
Case Two: The market acts as we expected, and price moves in our favor, but on much higher volatility. This will not be the norm, as we have set up the trade based on market conditions, but it can happen, albeit rare. This type of scenario will account for less than 5% of our price action, but it will be dealt with the same as in case one. When we are short premium, we will buy the credit back if it gains 30%. This is not the same thing as allowing the underlying asset to move by 30%. The ATM option or vertical should never represent more than 10% of the underlying stock, so that when we allow the premium to expand by 30%, it is the same as taking less than an approximate 3% stop loss on the underlying stock. When we are short premium a straddle is still considered double premium and we take our loss at an increase of 30% of the value.
Case Three: The market gets in tight congestion, but volatility explodes. This too is rare (about 5% of the time) and difficult to deal with. The reason that this will be so difficult is that there will seem to be no danger. The market price has not changed, but the options keep getting more and more “air”. This is a dangerous situation; the most likely result will be a huge breakout.
Regardless of what the underlying price does, we will buy the credit back if it gains 30%. Essentially, all possible problems that can occur being short premium will be handled in the same manner. We will accept a 30% negative movement in the price of our options, and will then buy our credit back and take the loss.
Long Premium with Positive Time Decay
This type of trade that we use is buying calendar spreads – trades in which we are long premium “the air” but short time decay. This trade has a couple of unique advantages; as you have surmised, it also has unique risk.
Being long calendar spreads creates a debit spread, but at the same time positive time decay. Hmmm, seems like the ideal position, if we stay here you make money from positive time decay, and since it is a debit spread, if we move we know a debit spread makes money, so what could be the problem?
The problem with trading calendar spreads is that a couple of events can hurt you: 1) The market breaks out suddenly, or 2) The market gets in congestion and volatility implodes.
In a sudden breakout (event #1), the first leg of the calendar will move the parity very quickly. Once the option moves to parity, we know that there is no time decay left, and the option will fall to the stock price and it will move one for one. If the second leg does not realize enough premium increase, it will become a loser.
As was the case with the earlier scenarios, we will accept a 30% negative movement in the price of our spread, and will then sell our debit back and take the loss.
Volatility implosion (event #2) occurs when the market expectation of traders is that it will never move again. Clearly, that is an overstatement, but you get the picture… the word “complacency” comes to mind. In this case although we still profit from our time decay, the air may come out of (the premium decreases in) the long leg at a faster rate.
Different event, same solution: we will accept a 30% negative movement in the price of our spread, and will then sell our debit back and take the loss.