Ep 83: Option Trading – Theta Decay & How it Works!

May 5th, 2016

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Hey this is Sasha Evdakov and welcome to another episode of Let’s Talk Stocks Episode Number 83.

This week we’re talking about Option Trading and Theta Decay and How Does it Work. And how does it affect your trades.

The last couple of days we’ve discussed day trading, when to trade, when to sit out. We’ve also talked about the Intraday action and day trading and social media as well.

We’ve got a lot of day trading action that I’ve discussed over the last couple of weeks and this week I thought let’s talk a little bit about option trading. Some of these topics we’ve been covering are a little bit more intermediate topics.

And we’re slowly moving into that direction after a few years of doing this vi deos because I’m able to kind of catch up many people through some of the old videos or point people in that direction. So we’re slowly moving into more I guess intermediate.

All these other things we’ve been talking about were still basic, it’s the basics. And there’s a lot to learn when it comes to the basics.

Today I want to just discuss few things regarding options, couple of quick notes on the market, I did post a handful of charts here for the Critical Charts members.

So if you haven’t had a chance to take a look at it be sure to take a look at it, its 14 charts and you can also take a look at the previous week as well which has a handful of charts in there that could still apply. So be sure to check those charts out.

I’ve also posted a handful of little mini training videos for the members on how to use the charts inside the website, how to find an exact price, terms and definitions that are used within the charts, and a few ways to get chart notifications so that way you’re more alert.

Looking at the overall market

Those are some of the videos that you can take a look at if you’re a member, just login and you’ll see that on your main page. Looking at the overall market, if we take a look at the Dow Jones, here you can see we came into this resistance levels, resistance highs and now we’re pulling back.

It’s not anything that should be very surprising, if you look at the S&P, very similar concept right here. Stocks are not going to go straight up perfectly or straight down. So here again we came into some resistance there was also some resistance right here.

Then you had some longer overall previous highs way up here. Over all we’re hitting those high points where we were over bought.


If you take a look at the IWM, right there, you can see hitting resistance points and I’ve talked about this in the previous recaps here in the Let’s Talk Stocks session, so be sure to check those last couple of videos out as well because I’ve talked to you about going more short on the market.

Now looking at the overall market pullback, we can get a pullback to let’s say here on the QQQ to the 103 level and then maybe we’ll hang around there. You know I don’t expect it to get back to 95 or even on the S&P, I don’t expect it to comeback to 1832 right away because if we did that, you’d probably see even more major selling to accelerate as this was starting to roll over.

Now can we get there with times, yeah we can but it would probably be a little bit slower because this acceleration here you had volumes dry up and then a flush, huge acceleration down and that took it down quite a bit.

We went down 214 points within about 20 days. Here, we’re already pulling back in 7 days for about 40 points so even if we did another 80, 50, or 70 points here, we’d be down at the 2000 level so that’ll put us at 120 points from the highs.

Overall, I think the pullback will come back, we have some potential points that we can bounce and it’ll come back maybe to this level, 2040, is a pretty good support line, you may get it back down at the 2000 with time depending if we break that level.

And then from there we’ll see depends on if more selling accelerates and if it does then it can continue moving lower but for now those are the key levels and more important. So a little pullback right here, maybe fine.

For the shorter term you may get 1 or 2 days of pop here because we did have a few red days here over the last few weeks so you may get a counter trend bounce at this level because this is where consolidation happens.

And if you look at today’s action we didn’t really do much we stayed almost exactly where we opened. So again the volume’s picking up so something to watch but you’ve got to see how fast is it going to break so that’s kind of the key thing you want to watch and pay attention to.

Let’s take a look at some Theta, looking at Theta Decay and how does it work. I’m going to use the Think or Swim here from TD Ameritrade, which makes things a little bit easier to explain. You can use any platform that you like, that is totally up to you and your preference.

Here what I have is the Facebook stock, up, and what I wanted to share with you is compare just a basic stock purchase to potentially buying or trading options. So typically, what happens when you buy a stock?

And let’s just say Facebook, I’m not evaluating it for chart, not recommending it or like that, I’m just simply showing or using this as an example. So if we have the Facebook stock right here, and we’re looking to buy 100 shares.

You’ll notice that I have these Greeks – Delta, Gamma, Theta, and Vega. So typically the ones you need to be more concerned with are the Delta, the Theta and the Vega when it comes to options.

Now when you’re just buying stock, you don’t have a Gamma, Theta and a Vega, that only applies to options but you do have a Delta. So quick refresher, what does Delta mean? Well it means for every one dollar the stock goes up, you make or lose based on that Delta.

So in our case since we’re positioned to the upside for every one dollar that stock moves up, so right now it’s 117.75 so if I want 118.75 and the Delta is 100 so I’d make 100 dollars for that 1 dollar move in that stock price.

Now the same thing in the reverse, so if it went down 1 dollar I’d lose 100 dollars, and of course this stacks so if I had 200 shares, if I went 1 full dollar I’m making, profiting 200 dollars or the other way if it goes down, I’m losing 200 dollars.

If you do this in shorting, if you’re shorting the stock, it works in the opposite way. So with the negative 100 Delta, negative Delta, you need the stock to go down. So going down you make 100 dollars and to the upside you would lose 100 dollars because you have a negative Delta.

To keep things simple right here, let’s just use it to the positive side for the time being. That’s basically a stock purchase of a hundred shares. Now when we look at options contracts, here are all our options that we have.

We have the calls here on the left which you can see indicated here on the top and the puts on the right, if you’re using a different trading platform, again, you should have something somewhat similar where you get the calls on the left and the puts on the right, they may be on the side, they may be on a dropdown but in either case you’ll have calls and puts.

Calls are typically for the upside and puts are typically for the downside bets. For example, if I’m looking for upside bet to 125 dollar range and here is the time value that I have. This is the June, so I have 43 days remaining.

If I wanted to go to July I’d have 71 days remaining. So if I wanted the 125, is the strike price, here’s the 125 so I right click buy the order or I can just go ahead and just click it and it’ll pop up, right click analyze the trade and they’ll put in that trade to tab for me.

I can remove that stock purchase and now you get to see here what happens to this trade. Now here we don’t have expiration graphs yet in these position so let me see if I can set that up so you can see how that’s going to work.

So you can see it’s a little bit different. One contract, remember, refers to 100 shares or controlling 100 shares. So this contract that I have is based on the 125 dollar strike price so it’s 125 and you can see that’s where the angle of this curve starts to change.

And you’re buying, you’re paying 230 dollars. Hence, right here the buying power effect is 230 dollars on that contract. So now what happens is as this stock goes up, you still profit right there based on that delta but notice that that Delta is different than controlling 100 shares of stock.

Here our Delta is 30, whereas here we have a hundred Delta so when we have here a 30 Delta, that means for every 1 dollar move in the stock here, I only make 30 dollars. Then this curve is an accelerated curve so it continues to move and accelerate in this way.

It’s a little bit different that in linear view when it comes to a stock, right here. Here because this is an accelerated curve, you have other factors that play in.

So with options, what happens is since they have a time value, the simple version of it is the way that they get the price is there’s a lot of underlying value to the contract itself plus you have time value, premium and all these good stuff they mash it all together and outcomes this 2 dollars and 30 cents.

And you can see that this 2 dollars and 30 cents is what you pay when you want to buy it, you can sell it for 2.27 and the Beta has spread the 3 cent difference here is what the market makers make.

If you go here to the little bit lower one or the higher priced one to the strike price of 130, you get 1 dollar and 12 cents but now the probability of this happening goes down. So the further out you go, the less probable this will work out.

So what does this allow you to do? Well if you buy a call option and within 71 days, it goes past your strike price which is all the way over here, let’s say it goes to 135, it allows you to have the right to buy that stock at the 125 strike price because that’s option you’re buying.

You will have the option to buy this stock at 125 even if it’s at 132, 138, 143, it doesn’t matter what price it goes up to, you will have the option to buy it at that higher price if you have that option contract at 125.

Now if it doesn’t get there, you lose your money, you lose your investment amount and at expiration, this can be significant. So at expiration you can see here on the lower left how much money so if the stock doesn’t move I lose 230 dollars.

And you can see I don’t lose any more than that because I’m buying an option so I’m buying a single option.

In this case, I’m losing money day by day. Now as this continues to move and increase in value I still lose money every day on a single option contract. Here, how this works is based on your Theta amount that is the amount you lose every single day that stock stand still.

As I move this day forward, this is hypothetical of course, you can see that my profit loss goes down to 45 dollars within a couple of weeks here. As I continue to do this it continues to increase, the losses continue to increase.

And not to mention my day loss per day losing 3 dollars per day continues to increase as well. It continues to increase 3 dollars and 60 cents, 3 dollars and 80 cents. So it continues to increase and if it’s up here it actually increases even more because that’s your kind of peak.

So this is not the area you want to be in when you’re losing money. It’s better when you’re at here at the top or even down here but at this point you’re already losing quite a handful of cash.

You can see that because this is at this apex point is where you have the most you’re losing per day. So here you’re losing 6 dollars per day.

If you continue doing this, you can see that every day I shift that stock up until July I’m losing 6 dollars per day and now it gets up to even 15 dollars per day and now here I’m at a 115 dollar loss.

So I need this stock to move that even though I’m buying the call at 125 I need it to go pass 127.30 because that’s my breakeven point at expiration.

Quick Notes

Couple of quick notes, if this stock moves within a day, 2 days, 5 days, or a week, it doesn’t matter pass this 125 level since you will lose a little bit of money, right? A couple of dollars in Theta but you’re all the way up here, you can sell it at any point or anytime you want and you would get 494 dollars where the white line is.

The white line is the current time, the current date based on what I have shifted here, if it was today which is May 5, if it was today it’d be $520. If it’s at expiration you look at this green line and you look at this lower box, it would only be a $157.

So that’s what happens is that as I continue to shift, you’ll notice this profit and loss over here starts going down so you’re losing money. So this is how Theta works and it works based on a steepness acceleration curve.

The closer you get to your day or time so say you’re 43 days out or 15 days out that Theta starts to accelerate faster and faster.

Theta Option curve

If you go ahead and search for the Theta options curve, you’ll be able to see how this decay really starts to work and accelerate, really this is what happens, is that this curve starts to kick in.

And here’s a base example where you can see that in this chart right here where you have a 120 days, so here you have 120 days to go until the option, you slowly start that small decay but then it continues to slightly accelerate really accelerate 60 to 30 days and really kick in less than 30 days.

So if you’re a buyer of options, you definitely don’t want to be in the 30 day or less time frame because it starts to accelerate really quickly. You can see these curves they’re a little bit differently but as you play more with options you’ll get the hang of it and how it works.

Typically, for most people, buying options is a waste and it’s a waste in a sense that they don’t understand how this Theta works and they keep losing money and they don’t understand why they keep losing money. And if you didn’t know this is the reason why you’re losing money.

Now typically, the better approach to nullifying this Theta or kind of negating it, is to sell something, to sell something on the other end. So, here we have a contract that we’re buying over here, but you want to also sell something.

Now this will cap your profits and this is really getting into a vertical. So I’ll go ahead and click one of these and analyze the trade. And you’ll be able to see here what I’m going to be doing. Let’s see here. Doing selling one is what I need because we bought one and we sold one at the 140.

Here’s what this does, is it, you can shift this around and you can see the difference the difference here in the Theta shortly. So what I’m doing here by selling one at the higher end is that I’m capping my profit potential.

This one, when I’m just buying a single option contract, it allows me to have unlimited profits and although that sounds fantastic and great, the probability of Facebook stock in the next let’s say 60 days that I have this contract to going into 200, because right now it is at 117, the probability of it jumping that fast.

Let’s just look at Facebook, of going to 200, let’s just say all the way up here, sounds lovely but it’s not realistic. I mean this stock over the last few months has really just moved 26 points. So for me, it doesn’t really matter that I kept my profits are at the end.

So, if I had just one option contract like this to the buy said, it gives me unlimited profits, but the problem is I’m losing money every day that standstill and I’m losing $2.98. If I bring it in closer, let’s just say the 120, I’m losing $3.54, which is even tighter but my probabilities here at the 120 are a lot better because that stock is at 117.

I’m losing $3.54 per day and that’s from now, and that’s going to continue to accelerate as time moves forward. So what I can do is I can cap the possibility of this stock. Let’s say moving 10 or 15 points, and let’s just say sell one option contract at the 135 level and what this will do is cap my profits but it eliminates my Theta or drops it down to -2.22.

So I went from a -3.54, to now a -2.22, so it really helps me out quite a great deal. So my max loss also is -3.78, whereas without it I’m losing -4.25 if the stock stands still.

By selling this one at the upper range, it allows me to capitalize and mitigate some of those loses because this business is about knowing and understanding your risk and minimizing those loses. And if you go to the 130, and you cap it at the 130, you’ll reduce that even further.

Here, your max loss is -316 versus without it, -425. So you can see that I’ve limited it but now m upside, the most I can make is 684, no matter how high that stock goes I’m only going to make 684 but that’s okay for me because I know that even if the stock goes to 140 I’m making a pretty good return on investment here from 316 risk to making 684 which is basically a 1 to 2 risk to reward ratio so I’m potentially making twice what I’m risking on that return.

And if you catch that at the appropriate chart move then you can definitely capitalize and you can do this the same thing on the other side. If you went ahead and did the put side, of course you can do the directional side, so I could go ahead and buy.

Let’s just do it this way because it’s off-screen here because I made the screen bigger to record the video. We’ll analyze this trade, so now I did the put side and now I’ll go ahead and sell one here at this price level.

Now I bought one, I’ve sold one. Let’s just drop this down a couple of contracts. Let’s just say two contracts and now I have a put vertical right here that’s to the downside. So I did the same exact thing where if that stock goes up a little bit I can go ahead and capitalize on those profits.

I’m risking 320 to make 680. If I wanted a higher risk to reward I could go ahead and shift this. So what can I do? I can go ahead and go to let’s say the 105 over here and now I can have a 520 versus a 480 profit potential which is almost a 3 to 1 but the stock needs to move at expiration until 104.

The beauty behind Theta now is when you have a spread like this whether it’s to the call side or the put side, is once we get past this level, you actually start making money from that option decay because you sold one, because you’re selling one.

Now, what happens to this curve is you notice it starts moving, shifting a little bit differently. Now after a while if you’re right there in the center it’s going to go back to negative because you need to get in front of a certain apex on that turn.

If you’re going over here, you can see you’re making $5 per day if that stock stands still. So, now you can go ahead and make that $5 or $10 or $12. You could see it keeps accelerating because of that acceleration curve and now you’d be up at $21 per day, up until that remaining point.

And even if the stock just stands here and doesn’t move you make your $1480, and it doesn’t matter if it moves down all the way over here, you’re still online going to make $1480. If you just simply had the put option, of course you would make a lot more, you’d make $6000 but again the probability of those things to happen is slimmer.

Again, work your probabilities and watch your risk. That’s what you always want to do in this business. It’s a risk management and money management business.

That’s really how Theta works. That’s kind of the baseline behind it and if you’re just buying single individual options, you’re probably losing out based on that Theta decay because every day that option just stands still it’s like dead money.

It’s like dead fish that continue to rot and continue to lose money on a day by day basis. You need to get rid of that inventory fast. Now on the other hand, if you sold one against it, just like we showed with the vertical then you’re starting to make more money as it’s moved in your favor because you’re capitalizing from that expiration of that premium, because now you’re a seller of some options.

That’s typically where you want to get to, you want to be a net seller of options most of the time. and I have a really detailed video here, Episode 75 on trading options as well, which is where we get into spreads and maybe that’s a little bit more of an advanced video.

That’s why I wanted to share with you this Theta video about how Theta works and how it really works within option trading so that way you get some insights.

So if you’ve watched this video first and then go to Episode 75, it’ll be a little bit more helpful because Episode 75 is a little bit more advanced and more complicated, that’s where we get into selling spreads and calendars and butterfly spreads and things like that.

That’s where I discussed some of those strategies. That’s how really money is made with these option contracts. So take a look at Episode 75, if you’re a little more advanced and you’re getting a hang of these option contracts.

But I just wanted to go in detail about this Theta decay within options because I know a handful of people e-mailing me, getting confused, or I’ve talked to you on the phone and they get burned by options because you’re not understanding what’s going on underneath the surface.

And this Theta component is just one of the components behind it. You also have your Delta, Gamma, and your Vega which are the other components you need to know and understand.

Now this is just a taste of it. I’m still working on my options course which I still have two main course sections that I need to finish out. Once that’s finished, we’ll be releasing that course in the summer time here soon probably within the next couple of months here as we finish out editing those videos.

It’s a massive course, its multiple courses, really when you think about, one of the largest courses I’ve created so far, but it’s really in detail. It’s really detailed in how to trade options because this is really advanced stuff.

You need to know and understand these probabilities, these volatilities. You’re also going to be looking at how much or how many people are trading the open interest. You need to know these things when it comes to options because you don’t want to be stuck on these option contracts.

Like in certain options like the CMG stocks where they’re trading lighter or even price line where it’s even lighter here and that’s some of the things that you need to pay attention and watch too. The more studying you’ll do the more you’ll understand because you’ll see different scenarios and situations.

So always trade lightly until you get the hang of things and if you’re constantly trading the same thing like buying a call or buying a put like this and you’re getting burned and you’re losing money on this, then stop doing the same thing over and over again, you probably need to learn a little bit something in order to continue and better your education.

Pay per minute coaching

So if you want we can schedule a consultation, a coaching session where you and me we look on screen, we look at your screen, I can share with you my screen and we can really drill down some of the problem areas that you have.

If you go to the website, you can just go to this page: Pay Per Minute Coaching and I’ll help you out. I’ve done a handful of these already, tons of people have scheduled sessions with me and we’ve shared the screen, we’ve done it through Skype and really get into it all about you and your personal problem areas.

We just go on screen, looking at the charts, looking at your strategy, what you’re doing and just discussing a handful of things about you and how your trading applies to your risk and reward strategies.

Final reminders

In either case, if you’re doing this on your own and you’re just playing around and you’re trying new theories and concepts, you got to know and understand these things. Start researching the Theta, Vega, Gamma and Delta – those are the things you want to pay attention to.

And when you’re just buying single option contracts like these Thetas right here, they continue to work against you. So, study and learn your business. This is your business, this is your craft. If you don’t know and understand what you’re doing in your business with your money then you’re just simply putting it place some place where you don’t know the end result.

Study it, learn it, continue to evolve and then grow and be consistent. Once you have consistency eventually, BOM, the light bulb flips and you got it. You got it, you can write your own ticket for your future.

Thanks for joining me in this video, I hope you found it helpful, maybe it was a little basic for some of you but really you need to understand Theta, and go back and watch Episode 75 if you haven’t seen that Episode or just to brush up on it, because really that’s going into even more detail when it comes to options.

Thanks again for sticking with me!

Remember, do what you love, contribute to others, but most importantly live life abundantly. I’ll see you next time!

Author: Sasha Evdakov

Sasha is the creator of the Tradersfly and Rise2Learn. He focuses on high-level education speaking at events, writing books, and publishing video courses on business development, internet marketing, finance, and personal growth.

I'm Sasha, an educational entrepreneur and a stock trader. In addition to running my own online businesses, I also enjoy trading stocks and helping the individual investor understand the stock market. Let me share with you some techniques & concepts that I used over the last 10+ years to give you that edge in the market. Learn More

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