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
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