Anyone know how to profit from Theta decay in options? while hedging the effects of almost eveything else. I quite know that this can be done and in fact it is done by the lot of people. However, I know less about how to do it? Thank you for answering.
TL;DR: Sell an OTM vertical spread for cheap. Go from there.
There are many ways to answer this. The basic premise is going to center around selling options. So let’s say you sell both a call and a put at the same ATM strike. You have high Theta, but now you’ve exposed yourself to both Vega and Gamma, even though you’re Delta neutral to begin. So, let’s instead sell far OTM strikes to reduce your Vega. You’re now still delta neutral, with less exposure to Gamma and Vega. But things will always move, and your gamma can turn into delta pretty quickly, so you’ll have to constantly hedge delta to remain neutral which drives up costs and can take away your hedge. You can reposition in many ways, both by changing strikes, # of contracts, or even expirations. Nearly infinite ways of doing so. Start by selling a simple vertical spread, out of the money. This will have positive theta and although you’re exposed to delta (and somewhat vega), you’ll get the feel for how things interact.
Because theta is 100% predictable (time always moves at a rate of 1 day/day), can anyone really make a profit on this?
Theta on a vanilla option is the price of 1 day of insurance, basically (or at least proportional to it). If IV is consistently higher than RV, then you profit over time, other things equal.
So maybe you don’t profit from Theta. Rather, you profit from the IV-RV average spread, but it materializes through Theta decay (over a portfolio of options over the long term).
From a more basic perspective, profiting from theta is what the “iron condor” set up is all about. ( sell a vertical call spread and sell a vertical put spread both OTM). Essentially you are just collecting the time decay (theta) while the long and short wings of the strategy hedge out the price change due to fluctuations in the underlying.
Err. Well on a high level, gaining theta, and assuming you hold the option position until it expires, means you are short realized volatility over the life of the option. For example, let’s say you sell an option priced with 20% implied volatility and delta hedge the position through its life. If realizes volatility is 21%, you should in theory, lose 1% times vega. If the option realizes 19% volatility, your gain should be 1% times vega.
That’s about it. You will lose on gamma when you gain in theta. You should just try to sell options at prices where implied volatility is higher than your expectation of realized volatility. If so, you gain more in theta than you lose in gamma.
There’s more decision making to do with respect to strike or maturity, but you should read a book on that before asking questions here.
Edit: with respect to all these spreads that people are talking about. Think about the thousands of different paths that the spot underlier can take. If you for instance, sell a call spread, you are essentially selling the nearby paths but buying paths that lead to the higher strike. The legs are priced at different implied volatility since different paths are assumed to also coincide with different volatility. There’s some math that I used to know but forgot.
Thank you for all your answers. However, they aren’t what I expected. Anyone know where I can read up about shorting premium while being hedged?
So, you basically want to make free money? In that case, the only rate you will earn is your funding rate, unfortunately.
I thought I just explained what theta is…
If you want return with no risk, just get elected to congress in a safe district.
lol