The Great Theta Deception in Options Trading
The Great Theta Deception in Options Trading
By:Kai Zeng
Theta's reliability as a predictive tool diminishes as the option approaches its expiration date
Options trading, unlike its counterparts in stocks and futures, introduces a layered complexity that requires a deeper understanding of various factors affecting profitability. Among these, theta, or time decay, plays a pivotal role in shaping the daily profit and loss (P/L) for traders. This concept is particularly relevant as options near their expiration date, but how reliable is theta as a predictor of daily returns throughout the option's life cycle?
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Our exploration of the relationship between Theta and daily P/L reveals a fascinating pattern, particularly when analyzing Standard & Poor's Depositary Receipts (SPY) strangles with varying deltas (16, 30, and 50) and 45 days to expiration (DTE). Initially, the difference between daily P/L and theta is minimal, suggesting theta offers a fairly credible prediction of daily returns at the start of the option's life cycle. However, as we move toward the expiration date, this relationship starts to deviate.
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An interesting finding is that the deviations between predicted (theta) and actual daily P/L become significantly pronounced in the latter half of the option's life span. This change is consistent across all studied delta strategies, indicating theta's reliability as a predictive tool diminishes as the option approaches its expiration date.
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The size of the option's delta further complicates the predictability of daily P/L based on theta. For larger delta options, the discrepancy between the daily P/L and what theta predicts becomes even more pronounced. This suggests that while theta could be used as a rough guide to estimate daily earnings in an option’s early days, its effectiveness decreases for options with larger deltas as they near expiration.
In practical terms, traders holding positions around the midpoint of the expiration cycle, for instance, around 21 DTE, should recalibrate their expectations regarding Theta's accuracy.
Understanding that theta's predictability wanes, especially for options with larger deltas, can help traders set more realistic expectations for their daily returns as the expiration date looms closer.
Click on the video below to learn more.
Kai Zeng, director of the research team and head of Chinese content at tastylive, has 20 years of experience in markets and derivatives trading. He cohosts several live shows, including From Theory to Practice and Building Blocks. @kai_zeng1
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