Making Cents From Theta Decay You Can Do It Too
There are as many option trading systems out there as there are bright young traders looking to make a buck. Unfortunately, not all systems are made equal. Choosing the wrong one, or using it incorrectly, could lose you a substantial chunk of your hard-earned capital.
A widely touted stock option trading strategy out there in common use today is the idea of "theta decay." At first glance, the name isn't indicative of something positive, but in reality, the concept capitalizes on a well known fact about option trading - options expire on a set date.
One result of this is that option values change over time. In particular, they change significantly when their expiration dates are drawing near. For example, options traders have learned that option values tend to drop as the strike date approaches.
The reason an option trading system using theta decay analysis works is because there is a more perfect information system in place for options than stock issues. Option trading is a more information efficient market because of the expiration date. Keen traders who keep up with the information flow can stand to make big gains from a system using this analysis.
How does one benefit from theta decay in their stock option trading system? The answer is simple - you take advantage of the time value of money, and its tendency to change faster closer to the expiration date. Analysis shows that the time value of an option drops linearly until the last thirty or so trading days prior to expiration.
It is those last thirty days when theta decay techniques are most effective. During those last thirty days, the rate of descent for the time value becomes steeper. But you can profit from this accelerated loss by holding the right positions.
For example, you could hold a short position in an option approaching expiration while simultaneously selling an inverse call option. This benefits you in two ways. First, you reap a benefit if you sell the call at a premium compared to the actual value. Second, you can also realize a gain on the short position, assuming that the option does not finish in the money on the positive side.
If you get your timing right and keep an eagle eye out for option information, theta decay is a useful tool to employ with your stock options trading. As with any system, there is always the possibility of losing your principal through incautious application of the technique. However, if you are attuned to the market and carefully scrutinize expiration dates, you can easily find yourself making money with this effective and under-utilized strategy.
A widely touted stock option trading strategy out there in common use today is the idea of "theta decay." At first glance, the name isn't indicative of something positive, but in reality, the concept capitalizes on a well known fact about option trading - options expire on a set date.
One result of this is that option values change over time. In particular, they change significantly when their expiration dates are drawing near. For example, options traders have learned that option values tend to drop as the strike date approaches.
The reason an option trading system using theta decay analysis works is because there is a more perfect information system in place for options than stock issues. Option trading is a more information efficient market because of the expiration date. Keen traders who keep up with the information flow can stand to make big gains from a system using this analysis.
How does one benefit from theta decay in their stock option trading system? The answer is simple - you take advantage of the time value of money, and its tendency to change faster closer to the expiration date. Analysis shows that the time value of an option drops linearly until the last thirty or so trading days prior to expiration.
It is those last thirty days when theta decay techniques are most effective. During those last thirty days, the rate of descent for the time value becomes steeper. But you can profit from this accelerated loss by holding the right positions.
For example, you could hold a short position in an option approaching expiration while simultaneously selling an inverse call option. This benefits you in two ways. First, you reap a benefit if you sell the call at a premium compared to the actual value. Second, you can also realize a gain on the short position, assuming that the option does not finish in the money on the positive side.
If you get your timing right and keep an eagle eye out for option information, theta decay is a useful tool to employ with your stock options trading. As with any system, there is always the possibility of losing your principal through incautious application of the technique. However, if you are attuned to the market and carefully scrutinize expiration dates, you can easily find yourself making money with this effective and under-utilized strategy.
About the Author:
TheScienceOfTrading.com provides 90 free minutes of videos on option trading systems and provides a complete and detailed learning to trade options for beginners to experts.
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