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Welcome to Part 7 of my series on the Greeks. This article will focus on Theta and managing this heaven-sent Greek throughout the life of a trade.
As mentioned in part 6, I try to take advantage of time decay as much as I can in my trading. Be that in butterflies, calendar spreads, or selling spreads - credit spreads, iron condors etc.
One important thing to know is that Theta’s value, like Vega’s (see part 4) can actually increase or decrease with moves in underlying stock price and changes in IV levels. In the case that we were using a selling strategy, a time friendly trade like a Calendar Spread for example, whether Theta is increasing or decreasing (with stock and IV movements), Theta is still a positive value. But what I want to make you aware of is that in every time friendly strategy, Theta can still be negative in some areas of the risk graph, and work against us.
The point on the risk graph where Theta switches from a positive value to a negative one is the point where the four coloured lines converge.
Chart 1
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Chart 1 is a Calendar Spread on CA – Computer Associates. Notice the 2 points where the lines converge. On the upper and lower sides of these convergence points is where Theta actually goes from being positive to negative. Have a look at Chart 2 and the green shaded area is where Theta is positive, the red where Theta is negative.
Chart 2
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Chart 3 is a similar example with an out-of-the-money Call credit spread on the SPY.
Chart 3
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Notice the one point of convergence here in Chart 4, and the areas where time decay in the credit spread would be positive and negative. Yes! Did you know that credit spreads have areas of negative time decay as well?
Chart 4
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So how do you manage this? Well in the first example (Chart 2) the way we make money in a Calendar spread is through time decay, through having positive Theta. If the stock went into the regions of the red shaded area then there’d be no way to make money out of this trade anymore (other than with a significant IV increase or movement in stock price).
Waiting until the stock made it into the red zone however would mean you incur a little loss in the trade. If your trade plan was to get out if the stock reached the breakevens then you would be out before it made it into the negative Theta area.
But how could we manage the Greek here, and turn our Theta from negative back to positive if the stock went up into the red zone and stayed there? This is an example of an opportunity where an adjustment could be implemented. Our Masters ICT course spends nearly the whole 3 days on adjustments, but the way I would go about one here is ask these questions:
- Where is theta positive? The answer is in between the two points of convergence, or (almost the same as) in between the expiration breakeven lines.
- How can I get the stock back in between the Calendar breakevens? The answer is we can’t move the stock, but we can certainly move the trade! You could roll the Calendar spread up a strike so the stock was now between the breakeven points and in the mouth of the Calendar again.
Manage your Theta!
Matt Baker
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