Targetting Theta in your options trading
‘Time is money’ is an age-old adage that can be precisely applied to options trading. Out of all Greek phrases, this is the most easily understandable, and anyone can easily calculate Theta (time value). The more time that remains until expiration, the greater the time value of the option. Time cannot be reversible, and this is the only Greek phrase that continuously erodes. As everyone knows, a vast majority of out-of-the-money (OTM) options expire worthless at the expiration. This is where market makers or option sellers make money. It is wise to take the most probable money, which is almost guaranteed in any market rather than hunting for unknown money.
Before explaining this philosophy of value erosion (when time is the only value), let us know how option premium weighs. The time value of an option is the difference between its premium and intrinsic value. All the out-of-the-money (OTM) and at-the-money (ATM) options have only time values. The maximum time value exists when the option is ATM and unless these OTM or ATM options become in-the-money (ITM) options, they expire worthlessly. At expiration, options have no time value. If one understands this time value theory, it is easy to build an expiration strategy.
The most popular expiration strategies are short straddles and strangles. Last time, we had mentioned short straddles i.e. where we are selling both calls and put of ATM strike. As we know, the OTM options have only time value, and we also know that a vast majority of OTM options expire worthlessly; we sell out of the call and put. When you select the out-of-the-money options, it equals the distance to the ATM money strike. Simultaneously, if their premiums are also equivalent (a slight difference is okay), they are very well-paired. Short strangles is the directionally neutral strategy. If you know the support and resistance for an index or a stock, you can use the same strikes to build this strategy. As mentioned above, OTMs have a higher probability of expiring worthless, and this is exactly what we catch.