Positive Theta Should Be Your Friend

Posted on Thursday, October 10, 2019 at 3:24 PM

This market has been particularly volatile over the past several months. I am sure most of you have noticed that. Finding directional or even neutral trades that last for more than a session or two has been extremely difficult. But what if there was a way to help offset some of your delta risk? There can be and there is a way to do it with a proper long calendar spread.

A long calendar involves selling a call or put and buying the same strike call or put with a longer expiration. This position can have a positive, negative or essentially neutral delta depending on where the stock is trading in regard to the short strike. The key ingredient to the trade is usually positive theta. The short strike will have a bigger theta (which is positive) than the long strike (which is negative).

As time passes, positive theta can increase the spread’s premium. But in addition, it can offset some delta risk too. Take a look at the long calendar spread below.

The 57 call is sold and the following week’s 57 call is bought. The delta is essentially neutral (+0.5214 versus -0.5168) with the stock currently trading at $56.96. The best-case scenario for this trade is for the underlying to stay around the $57 level as close to short expiration as possible. Positive theta for the position (+0.1890 versus -0.850) is the key.

With the current positive theta close to 0.10, time passing would increase the spread’s premium by about $10 a spread. If the stock moves higher or lower, delta will become positive or negative. But because of the positive theta, it can offset some of the delta risk. In a market like we have seen this is possibly invaluable.

Fast forward two days.

The stock has cooperated and it is still trading close to $57 ($56.80). Delta is a tad more positive because the short expiration expires in a day. But check out the positive theta. It has ballooned from about +0.10 to over +0.40 (0.5050 – 0.0890). Not only is that bigger positive theta offsetting your delta risk, it is increasing the spread’s premium, which could lead to an eventual profit.

Clearly, a long calendar spread cannot perform miracles. If the stock moves far away from the short strike, delta will grow, and positive theta will not be able to offset the delta loss. But if the stock hangs in the general area of the short strike, positive theta will be your best friend as it should be.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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