THE BEST LAID PLANS OF MICE AND MEN OFTEN GO AWRY...
-Robert Burns, 'To a Mouse' 1785
The last few trades I've detailed on this blog have utilized options as the return drivers and linear equity as the overlay protection. This transformation was brought about by a seemingly simple question of how to increase efficiency. However, I am now faced with a new challenge as a result of being short the market and - now - also short theta.
So what happens if my best laid plans for a technical market correction go awry? If prices move against me, my positions are protected by equity exposure which will hedge the loss on the options, so I'm good there. But what happens if equity prices don't move? Even if equity prices stand still, time most certainly does not. That's when time becomes your biggest enemy.
THETA - EXPLAINED & VISUALIZED...
Theta is the price an option holder pays to own an option every day... if there is no change is any of the other pricing variables - namely implied volatility and delta - then the price of the option will decrease (decay) daily by the theta. Theta has an inverse relationship to time and is greatest for at-the-money options whose value is entirely extrinsic.
Before we go any further, let's take a look at what theta decay looks like visually.
Here's a chart of the put options for the QIHU short (http://tancockstradingblog.blogspot.com/2015/08/new-position-short-qihu.html)... the $65 has a -65 delta, the $60 has a -50 delta and the $60 has a -36 delta.
This chart shows the daily decay each option would incur over their remaining lives assuming the other variables remained constant. As they near expiration, the rate of decay in the out-of-the money and at-the-money options begins to increase... especially the $60 put, as it nears expiration the decay begins to accelerate exponentially because it's value is purely extrinsic yet its' 50 delta kept the price high throughout its life. Notice, however, that the longer the time to expiration, the lower the rate of decay is.
Here's a surface chart that shows the amount of theta that decays daily on a low volatility SPY option across strikes with just 10 days to expiration. The middle of the surface represents at-the-money options.
THE HOW AND WHEN OF HEDGING THETA...
I've recently outlined two trades that use options as the return drivers... they're both shorts (long put options, long stock) and the options on both trades expire on September 18th. The extrinsic option premium makes up more than 15% of the capital allocated to these two trades... that's a lot.
Here's a look at the daily combined theta decay that will result from these trades assuming the stocks don't move...
When to hedge theta:
The biggest problem with hedging is that it's expensive... the price you pay to hedge drives up the return your initial investment has to earn just to break even.
Looking at the chart above, I see that during the first couple of weeks of this trade the costs are manageable... assuming the stocks don't move. But the trades were put on specifically because I think the stocks will move. So I'm fine not killing my trades with hedges during the first couple of weeks. Also, what if one names moves and the other doesn't... if I hedge too early, I'll have wasted money hedging the whole exposure when it wasn't necessary.
If I get within 7 days of expiration, however, and the underlying stocks still haven't moved then I'd have a decision to make. At this point, cutting the trade and taking a loss wouldn't be a bad idea at all as there's still about 45% of the option premium remaining. However, if I was inclined to stay in the trade, I'd probably look to hedge that remaining premium in an effort to protect it.
How to hedge theta:
The second biggest problem with hedging is that it can be inefficient. Basis risk is the exposure that results from hedging one asset with another one that is not perfectly correlated. To hedge this theta exposure, I'll be selling short dated SPY puts... this creates basis risk. The point of this trading strategy is not to create risk-free returns... so at some point you just have accept risk.
If I do decide that I want to hedge theta, I need to re-evaluate the original trade to see what losses I'm going to try to offset. Here's a look at the QIHU trade PnL chart again:
Assuming the price of the stock hasn't changed much since I put on the trade, it's probably still in the neighborhood of $63.87. What I want to hedge against is the area inside the red box... or the maximum exposure. If the price of the stock falls, I have a ton of option exposure there that will quickly limit my losses or better so there's no need to hedge to the downside.
By entering the original trade, I went long put options which made me short theta... so to hedge that exposure I'm going to need to sell put options in order to get some offsetting long theta. However, I can't sell puts on QIHU or SWKS because that would cancel the positions I already have on... I need a proxy. There are a couple of proxies that can be used... if you have a highly correlated sector ETF, I'd go with that but that's not the case here. Therefor I'll use the broad market as my proxy and sell puts on the S&P with the same expiration as my QIHU and SWKS options to try to capture some offsetting theta.
By selling the at-the-money put on the SPY and buying a lower strike put, I would set up a vertical bull-put spread. Using this week's options as an example, I could sell the 1 week at-the-money $209.50 put for $1.22 and buy the $205 for $0.3 giving me a credit of $0.92. As long as the SPY finishes at or above $208.28 at expiration, I would have offset part of my theta loss. If the SPY finishes below $208.28, then the hedge would have lost money that would have to be made up for by, hopefully, gains on the original trade.
As you can see, hedging theta is not easy and it's probably best to try to avoid it if you can. That doesn't mean it can't be done, however.
-Robert Burns, 'To a Mouse' 1785
The last few trades I've detailed on this blog have utilized options as the return drivers and linear equity as the overlay protection. This transformation was brought about by a seemingly simple question of how to increase efficiency. However, I am now faced with a new challenge as a result of being short the market and - now - also short theta.
So what happens if my best laid plans for a technical market correction go awry? If prices move against me, my positions are protected by equity exposure which will hedge the loss on the options, so I'm good there. But what happens if equity prices don't move? Even if equity prices stand still, time most certainly does not. That's when time becomes your biggest enemy.
THETA - EXPLAINED & VISUALIZED...
Theta is the price an option holder pays to own an option every day... if there is no change is any of the other pricing variables - namely implied volatility and delta - then the price of the option will decrease (decay) daily by the theta. Theta has an inverse relationship to time and is greatest for at-the-money options whose value is entirely extrinsic.
Before we go any further, let's take a look at what theta decay looks like visually.
Here's a chart of the put options for the QIHU short (http://tancockstradingblog.blogspot.com/2015/08/new-position-short-qihu.html)... the $65 has a -65 delta, the $60 has a -50 delta and the $60 has a -36 delta.
This chart shows the daily decay each option would incur over their remaining lives assuming the other variables remained constant. As they near expiration, the rate of decay in the out-of-the money and at-the-money options begins to increase... especially the $60 put, as it nears expiration the decay begins to accelerate exponentially because it's value is purely extrinsic yet its' 50 delta kept the price high throughout its life. Notice, however, that the longer the time to expiration, the lower the rate of decay is.
Here's a surface chart that shows the amount of theta that decays daily on a low volatility SPY option across strikes with just 10 days to expiration. The middle of the surface represents at-the-money options.
THE HOW AND WHEN OF HEDGING THETA...
I've recently outlined two trades that use options as the return drivers... they're both shorts (long put options, long stock) and the options on both trades expire on September 18th. The extrinsic option premium makes up more than 15% of the capital allocated to these two trades... that's a lot.
Here's a look at the daily combined theta decay that will result from these trades assuming the stocks don't move...
When to hedge theta:
The biggest problem with hedging is that it's expensive... the price you pay to hedge drives up the return your initial investment has to earn just to break even.
Looking at the chart above, I see that during the first couple of weeks of this trade the costs are manageable... assuming the stocks don't move. But the trades were put on specifically because I think the stocks will move. So I'm fine not killing my trades with hedges during the first couple of weeks. Also, what if one names moves and the other doesn't... if I hedge too early, I'll have wasted money hedging the whole exposure when it wasn't necessary.
If I get within 7 days of expiration, however, and the underlying stocks still haven't moved then I'd have a decision to make. At this point, cutting the trade and taking a loss wouldn't be a bad idea at all as there's still about 45% of the option premium remaining. However, if I was inclined to stay in the trade, I'd probably look to hedge that remaining premium in an effort to protect it.
How to hedge theta:
The second biggest problem with hedging is that it can be inefficient. Basis risk is the exposure that results from hedging one asset with another one that is not perfectly correlated. To hedge this theta exposure, I'll be selling short dated SPY puts... this creates basis risk. The point of this trading strategy is not to create risk-free returns... so at some point you just have accept risk.
If I do decide that I want to hedge theta, I need to re-evaluate the original trade to see what losses I'm going to try to offset. Here's a look at the QIHU trade PnL chart again:
By entering the original trade, I went long put options which made me short theta... so to hedge that exposure I'm going to need to sell put options in order to get some offsetting long theta. However, I can't sell puts on QIHU or SWKS because that would cancel the positions I already have on... I need a proxy. There are a couple of proxies that can be used... if you have a highly correlated sector ETF, I'd go with that but that's not the case here. Therefor I'll use the broad market as my proxy and sell puts on the S&P with the same expiration as my QIHU and SWKS options to try to capture some offsetting theta.
By selling the at-the-money put on the SPY and buying a lower strike put, I would set up a vertical bull-put spread. Using this week's options as an example, I could sell the 1 week at-the-money $209.50 put for $1.22 and buy the $205 for $0.3 giving me a credit of $0.92. As long as the SPY finishes at or above $208.28 at expiration, I would have offset part of my theta loss. If the SPY finishes below $208.28, then the hedge would have lost money that would have to be made up for by, hopefully, gains on the original trade.
As you can see, hedging theta is not easy and it's probably best to try to avoid it if you can. That doesn't mean it can't be done, however.
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