Why Theta decay alone is not a real edge for option sellers ๐งต
If there is one certainty in the markets, it's that all OTM options will expire zero. Human beings crave certainty & if it's mixed with a hope of financial gain, then they will leap towards it in the first go.
This is what attracts majority of people in option selling. The advantage & certainty of theta decay. Some people might actually start calculating the returns beforehand while taking their positions.
But what's the catch behind something that's certain? First of all we should understand the meaning of trading edge. An edge is something which gives us advantage over others. It's an approach acquired through rigorous efforts which puts us above rest.
Something that's acquired automatically, which applies for everyone else can't be a true trading edge. Option sellers having the same theta decay advantage, can have extreme varied results even with similar strategy just because of having some extra piece of knowledge.
With option selling we need to understand that we are aiming for limited returns by risking unlimited. Hedged positions do help in cutting the unlimited risk, but they also therefore reduce our profits & the risk is still high enough.
With the limited premiums we have collected in our strategy, there are forces of delta & gamma at play that work against us continously. Each delta move either requires an adjustment which adds on to the cost or will eventually hit our SL (in case of neutral strategies).
If the theta is high, then chances are that gamma moves will also be high. And we as option sellers don't want to mess with gamma. Caught in one wrong move can spoil many days of returns. Option buyers pay theta to get access to this power of gamma.
So if theta decay can be an edge for option sellers, the opposing force of gamma is an automatic edge for option buyers. Though there's no certainty to gamma surges, but they do occur quite frequently & if played skillfully can give max returns. Same goes for rising IVs.
With option selling our main aim is to achieve consistency. And consistency in itself is rarest of all human qualities. It requires tremendous effort as well as experience to achieve that year after year. Only through experience can we understand different volatility regimes.
Even if one has had few good years making consistent profits via option selling, few volatile months in between are enough to take him back to square one. It can break the confidence & the illusion of theta decay which looks quite convenient to begin with.
And such periodic volatility bursts are quite common in the markets. Only a skillful option seller can negate or avoid such periods. For others it can be a learning experience, provided they are able to survive.
What happens when everyone start selling options? We have seen the craze go up significantly since last few years. And so has the realised volatility. Now we are able to extract lesser % profits from the premiums pocketed. And it will keep increasing if the trend stays the same.
So look at theta as a feature of an option just like delta, gamma, vega are other features. Option sellers usually get many small winners & occasional big losers. The edge in the long run is to negate the big losers by gauging the volatility & understanding the market regime.
Theta being constant for an option seller, we need to be able to take the advantage of delta or IVs to truly create an edge. When to trade delta neutral or delta positive or negative, when to take advantage of IV spike or use volatility skews. Answers to such questions will help.
Majority want to stay in the comfort zone of not having any opinion on market direction or volatility by staying neutral all the time. Learning few strategies & adjustments through endless free sources on the internet & they're good to go.
This is exactly where the market catches them off guard. Luring by showing consistent easy returns for a period of time & snatching it away in an instant. Remember it's not just about the financial aspect but the limited precious time which also gets wasted.
Having too much confidence on the certainty of theta decay is something i have stopped having, being an option seller for more than a decade myself. I rely on understanding the market conditions first & using strategies accordingly. Theta is earned via following a process.
If you only begin looking at theta as free money than a lot of painful lessons are pending. Market is very efficiently designed. It doesn't go out there handing edges to everyone without putting in the effort.
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