Amir Atabaki is the Chief Publisher of the Time Decay Options Advisory Service at MCTO.

Amir Atabaki.

How the Greeks Affect Selling Credit Spreads and Iron Condors

When determining the best options to sell when trading credit spreads or iron condors, it’s important to understand the basics of how Delta, Theta and time to expiration play a role. In this article we will first define Delta and Theta, and then look at options over three different time periods to show the effect that Delta and Theta have when selecting an option to sell.

The first Greek to define is Delta. Delta represents the dollar value an option will move with an underlying $1 move in the stock or index. Delta also represents the probability an option will expire worthless. For instance if an option has a delta of .20 this would signify a 20% chance that the option will expire in the money (ITM) or an 80% chance the option will expire out of the money (OTM). For sellers of options in the form of credit spreads or iron condors you are most likely looking to sell options with a high probability of expiring OTM and worthless. The delta that we have chosen to examine is a delta of .15 for a call option on the SPX, or whichever is closest to that number over 15, 31, and 46 days to expiration. All of these options are out of the money. We will illustrate the effect that time has on distance from the underlying that one can achieve over these time frames. We analyzed these options on 11/14/16 with the SPX trading at 2160 and volatility (VIX) trading around 15.

                        Prob.        OTM          Delta          Theta       Mark                    Expiration                     Strike

 

 

The first option we look at expires on 11/28 or 14 days out. The option closet to a delta of .15 is the 2205 call option (delta of .14) with a trading midpoint of $2.67. As you can see with 14 days until expiration the option is 45 points away from where the SXP was trading, or 2.08% away. The theta for this option is -.29 and represents the daily rate of decay for this option.

Prob.        OTM          Delta          Theta       Mark                    Expiration                     Strike

 

 

Next we look at options expiring on 12/16 or 31 days until expiration. An option with a delta of .15 for this expiration is the 2230 call option and its trading midpoint is $5.25. The option is 70 points away from the underlying or 3.24%. The theta for this option is -.25.

Prob.        OTM          Delta          Theta       Mark                    Expiration                     Strike

 

 

Lastly, we look at the 12/30 expiration that is 46 day until expiration. An option with a delta of .15 for this time frame is the 2245 call option and its midpoint value is $6.10. This option is 85 points away from the underlying or 3.93%. The theta for this option is -.20.

There are three dynamics that are illustrated when looking at options with the same probabilities over differing time frames. First, an option’s theta or time decay will accelerate as it approaches expiration. Or in another way, the rate at which the value of an option will depreciate as expiration arrives. This is illustrated in the value for theta for each option. Each value is negative as time elapses and the option with the greatest impact from time decay is the option closest to expiration.

The second dynamic is that the further out in the calendar one goes the more expensive an option will become. This is due to the fact that you are paying more for time premium the further you go out in time, known as the extrinsic value of an option. All of these options are currently out of the money and hence any price that you pay for said options represent its extrinsic value as they have no inherent “real” value other than time. The more time to expiration that you sell the further you are able to move away from the underlying stock or index.

The third dynamic is that options that have more time to expiration are more easily adjusted. Periodically, an option that is sold will come under pressure by the underlying and it’s imperative to adjust and roll the trade into a new strike price and to push it out further in time to keep the sold option from going ITM. Credit spread adjustment methodologies are outside the scope of this article and for more information about how to adjust credit spreads please visit the MCTO website or contact us.

How one determines which option or spread to sell will be based on desired risk appetite and current thesis (bearish, bullish, or sideways). If you choose to sell the option that has 16 days until expiration the strike price of the option will be closest to the underlying (2.08%), but will also enjoy less exposure to time and have the most time decay. The option that has 46 days until expiration provides the largest cushion from the underlying (3.93%), but has the most exposure to time and the slowest pace of time decay. The option that has 31 days until expiration offers a mix of both distance from the underlying (3.24%), time exposure, and time decay. Each option has its pros and cons and is a sliding scale of risk and reward. The shorter dated options provide a margin for error in that time is working in your favor with each passing day, even if the market is moving against your position, as long as it remains out of the money. The further out in time that you sell an option, the less time and time decay work in your favor, but it provides the most distance between your option and the underlying. Moreover, as mentioned above, the longer time frames allow a trader to more easily adjust a position that has come under pressure.

We can see that Delta, Theta, and time to expiration can be used as a guide to help one select the appropriate strike and option that they wish to sell. Moreover, the time to expiration for the option that is selected will depend on the trader’s risk tolerance and desired distance from the underlying.

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