The most reliable profit drivers

The Most Reliable Profit Drivers

By:Dr. Jim Schultz

By far, the most reliable profit factor is time

  • While the market usually rises over the long term, how it might move in a 30- to 60-day time horizon is always random and unpredictable.
  • By selling options, you’re able to tap into volatility’s tendency to contract, but this profit factor is still difficult to quantify.
  • By far, the most reliable profit factor is time. By selling options you’re positioning yourself to benefit from the simple passage of time.

The reason anyone trades or actively engages with the market is to earn a return on their capital. Even more specifically, the reason why someone might actively trade as opposed to simply buying an S&P 500 Index Fund is to earn a greater return than the overall market. In the world of options, when it comes to profits, there are essentially three main drivers—and they are not created equally.

Direction (delta)

On a day-to-day basis, delta will be the biggest profit driver in a given position.

It will move your position’s P/L more than any other factor, as deltas often track to 30%, 50%, or 80%+ of an underlying stock’s price movement, and stocks often move multiple (or many) points per day. So, from an overall awareness and position adjustment standpoint, you certainly want to be cognizant of where your deltas are.

But given the general randomness and unpredictability of the market in the short-term, delta is your least reliable profit driver in a 45 DTE world. Yes, over time, we can reasonably expect the market to rise, so having a longer-term long bias makes sense. But over the course of the next 45 days? It’s anybody’s guess.

Volatility (vega)

Volatility is another factor that impacts the profit/loss (P/L) potential of your option positions.

Simply put, if you buy options, you are long volatility, and any increase in volatility will help your P/L. If you sell options, you are short volatility, and any decrease in volatility will help your P/L.

As Julia Spina shows in The Unlucky Investor’s Guide to Option Trading, only about 10% of the time is market volatility significantly expanding. This means that the other 90% of the time, market volatility will be stable, slowly contracting, or rapidly collapsing.

Therefore, by selling premium, we’re able to take advantage of market volatility’s tendency to grind lower, but from a reliability standpoint, it’s still difficult to quantify profitability expectations based on volatility. As a result, short volatility might be more reliable than the directional bias in your portfolio, but it still leaves something to be desired.

Time (theta)

Time is the last significant driver of option P/L. And it's a far more reliable profitability factor.

With short options, and specifically the positive theta they produce, you are positioned to benefit from the passage of time. So with every day that passes, given the extrinsic value in the option’s natural tendency to drift lower towards zero at expiration, your position’s P/L will benefit. Now of course, you’re not printing money, and nothing is a guarantee, as many things can (and eventually will) happen.

But by simply building positive theta, you’re able to tap into the most reliable profit factor of all—the calendar moving forward.

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3

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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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