Managing Portfolio Theta

Being a successful trader can often hinge on an ability to adjust.

This could be as simple as reading a news alert and quickly re-structuring a position to take advantage of a new opportunity. Or, it could be the ability to think around corners when surprising developments occur that affect the bigger picture (i.e. the recent Presidential election in the United States).

The tastylive financial network does its utmost to not only discuss and analyze current affairs, but also present a variety of options (pun intended) for expressing one's view in the marketplace.

One key that can be used for unlocking your innate ability to adjust is to embrace an attitude of continuous learning. If you are open to improvement, you can equip yourself with an increasing ability to take advantage of a greater spectrum of opportunities.

In a recent edition of From Theory to Practice the host (Dr. Jim Schultz) introduces another way of thinking about theta - specifically as it relates to overall portfolio management. A comprehensive understanding of the information presented on this edition of From Theory to Practice may be one such opportunity to build up your arsenal of trading knowledge.

Theta of course is one of “the greeks,” and more specifically the one that measures the rate of change in an options price relative to time (a.k.a decay). Options have specific expiration dates, so as time progresses (all else being equal), the value of an option goes down.

Looking under a microscope at a single option trade, this means that when you sell an option you can expect to theoretically collect a small portion of its value on a daily basis. Your position benefits when the underlying sits still.

On the other hand, purchasing an option means that you'll theoretically lose your theta on a daily basis, and that you are hoping for a move in the underlying stock that increases the value of your option (or increases the value of a hedge associated with the option).

On the episode referenced above, Dr. Schultz walks viewers through his perspective on theta at the portfolio level. Portfolio theta is the net value of your various positional theta. For example, if you are collecting $100/day of theta in XYZ and paying $100/day of theta in ABC, then your net portfolio theta is zero.

The point Dr. Schultz is trying to drive home is that while the deployment and management of individual positions is very important, strategic control of theta at the portfolio level can be equally critical.

One of the key elements that Dr. Schultz uses to illustrate portfolio theta is the "1/10th of 1%" concept he has discussed in the past. 1/10th of 1% (or .001) is a guideline that can be used to help approximate your net portfolio theta. In the example used on the show, an account with a value of $100,000 would result in a net portfolio theta of $100 ($100,000 x 0.001 = $100).

A portfolio theta of $100 would mean that a trader theoretically collects $100/day in decay. Taking that number and multiplying it by 360 days in a year would therefore result in portfolio of this size theoretically collecting $36,000 per year (360 days x $100/day = $36,000).

Dr. Schultz then goes one step further and applies this theoretical return to an episode from another series on the tastylive network. On Market Measures earlier this year, hosts Tom Sosnoff and Tony Battista present a study of historical S&P data that suggests a portfolio may capture approximately 25% of the total theta at risk over time.

Going back to the example used in From Theory to Practice, that would mean that a theoretical portfolio collecting $100/day, and $36,000/year, might reasonably expect to capture approximately 25% of that amount, or $9,000 ($36,000 x 25% = $9,000).

For the best possible understanding of this material, we recommend you watch both episodes focused on portfolio theta when your schedule allows.

While the approach discussed above may not fit your strategic approach and/or risk profile, it's all but certain the topics discussed on the two shows will help elevate your thinking.

Returns are of course never guaranteed, and are dependent on specific positions and prevailing market conditions.

If you have questions on portfolio theta or the concepts referenced above we hope you'll reach out at support@tastylive.com.

We look forward to hearing from you!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.