The 2 Sides of Negative Theta
The 2 Sides of Negative Theta
Positive theta indicates time is working for you, but negative theta means time is working against you.
- While positive theta means time is working for you, negative theta means time is working against you.
- Undefined-risk strategies never have negative theta. By having only short options, or at least more short options than long options, time is always working in the favor of an undefined-risk strategy.
- A defined-risk strategy that is fully in-the-money will show negative theta because unless the stock moves back in your favor, the position will trade closer to max loss
If you sell premium on a regular basis, then you are accustomed to having positive theta on your positions and in your portfolio. You like having time working for you, and you like trading the higher probabilities that come from the short side of the options contract. But is there ever a time when you have to carry negative theta on your short premium positions?
What negative theta means
While positive theta indicates time is working for you, negative theta simply means time is working against you. Instead of each passing day moving you closer to your profit target on a given position, each passing day moves you farther away from your profit target. Premium buyers know this metric well because every naked long call or naked long put has negative theta. The options buyer essentially has to buy the time needed to potentially cash in on the unlimited profits of long options. So, time is an enemy rather than an ally for the options buyer.
But the same can happen to the options seller.
When negative theta happens
Negative theta is never something you’ll see with an undefined-risk short premium position, such as a short put or short strangle. The simple fact that an undefined-risk position has only short options, or at least more short options than long options, effectively guarantees it will be positive theta over its life.
But with defined-risk strategies, such as a vertical spread or iron condor, there will be plenty of times when the theta on the position will flip from positive to negative. That happens when the stock moves against you, the position goes fully in-the-money and each passing day moves you closer to hitting maximum loss on the trade. In this scenario, time is working against you, the premium seller.
Now, does this mean you should immediately exit any short premium position that shows negative theta? No, not necessarily. Provided you have sized correctly, and your position size is small relative to your overall portfolio (usually 1%-3% of net liquidating value per defined-risk position), there is no reason to abandon a trade just because it is showing negative theta.
Remember that the probabilities on order entry were in your favor, and those probabilities included all possible outcomes in the stock, including the one you’re dealing with now. Therefore, staying the course and allowing the probabilities to work out over time is almost always the appropriate move.
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
For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.
Trade with a better broker, open a tastytrade account today. tastylive, Inc. and tastytrade, Inc. are separate but affiliated companies.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastylive content is created, produced, and provided solely by tastylive, Inc. (“tastylive”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, digital asset, other product, transaction, or investment strategy is suitable for any person. Trading securities, futures products, and digital assets involve risk and may result in a loss greater than the original amount invested. tastylive, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastylive is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparisons, statistics, or other technical data, if applicable, will be supplied upon request. tastylive is not a licensed financial adviser, registered investment adviser, or a registered broker-dealer. Options, futures, and futures options are not suitable for all investors. Prior to trading securities, options, futures, or futures options, please read the applicable risk disclosures, including, but not limited to, the Characteristics and Risks of Standardized Options Disclosure and the Futures and Exchange-Traded Options Risk Disclosure found on tastytrade.com/disclosures.
tastytrade, Inc. ("tastytrade”) is a registered broker-dealer and member of FINRA, NFA, and SIPC. tastytrade was previously known as tastyworks, Inc. (“tastyworks”). tastytrade offers self-directed brokerage accounts to its customers. tastytrade does not give financial or trading advice, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastytrade’s systems, services or products. tastytrade is a wholly-owned subsidiary of tastylive, Inc.
tastytrade has entered into a Marketing Agreement with tastylive (“Marketing Agent”) whereby tastytrade pays compensation to Marketing Agent to recommend tastytrade’s brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastytrade. tastytrade and Marketing Agent are separate entities with their own products and services. tastylive is the parent company of tastytrade.
tastycrypto is provided solely by tasty Software Solutions, LLC. tasty Software Solutions, LLC is a separate but affiliate company of tastylive, Inc. Neither tastylive nor any of its affiliates are responsible for the products or services provided by tasty Software Solutions, LLC. Cryptocurrency trading is not suitable for all investors due to the number of risks involved. The value of any cryptocurrency, including digital assets pegged to fiat currency, commodities, or any other asset, may go to zero.
© copyright 2013 - 2024 tastylive, Inc. All Rights Reserved. Applicable portions of the Terms of Use on tastylive.com apply. Reproduction, adaptation, distribution, public display, exhibition for profit, or storage in any electronic storage media in whole or in part is prohibited under penalty of law, provided that you may download tastylive’s podcasts as necessary to view for personal use. tastylive was previously known as tastytrade, Inc. tastylive is a trademark/servicemark owned by tastylive, Inc.