Two important factors related to options are time and implied volatility (IV). Their relationship tells us how much we are getting paid in theta (time decay) for the volatility risk we are taking. Tom and Tony said that another way to put it was the amount of (time) decay versus the expected move.
When we divide theta by vega and the result allows us to compare risk to reward scenarios. Since we want the maximum gain for the least risk we want to see a high level of Theta and a low level of Vega. Our research team ran a study in SPY (S&P 500 ETF), QQQ (Nasdaq ETF) and GLD (Gold ETF) from 2009 to present. We compared the theta / vega relationship on a 1 Standard Deviation Strangle with 45 days to expiration (DTE) and 75 DTE. A table displayed the results. The table included the average theta, average vega and average theta/vega ratio on both time frames.
We wanted to see the effectiveness of using the initial theta/vega relationship as an entry criteria. How does this metric affect the win rate and P/L on a one standard deviation strangle with 45 DTE? A table displayed the results of P/L. percentage of wins and average P/L per trade for theta/vega ratio less than 19%, between 20% & 29% and greater than 30%.
For more on the Option Greeks Vega and Theta see:
Market Measures on May 20th, 2015: “Risk & Reward | Vega & Theta”
Market Measures on October 19th, 2015: “Understanding Vega”
Market Measures on October 28th, 2015: "Understanding Vega | Directional Trades"
Options Jive on February 22nd, 2016: "Options Risks | Volatility (Vega)"
From Theory To Practice on March 24th, 2016: "An Intuitive Understanding of Vega"
Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the valuable takeaways and the results of our studies on the theta/vega relationship for an insight into risk versus reward.
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