Tired of losing most of your options trades? Don’t be ashamed of it. Most traders lose money trading options because they are on the wrong side of the trade. You will often be in a trade that has a 20-30% chance of being successful.
Theta strategies will put you on the right side of the trade. Theta trades give you a 70-80% of being successful. It almost sounds too good to be true.
How in the world could you go from a 20-30% chance of success to a 70-80% chance of success?
This post is going to explain to you all that you need to know to get started placing theta trades. You will learn what theta strategies are and the different types of theta trades can you can place.
Let’s get to it.
What Are Theta Strategies?
Theta strategies are advanced options techniques that let you use theta decay to your advantage. In other words, theta strategies put time on your side.
Theta decay is what causes most option traders to lose money. Have you ever had a trade that was spot on, hit your price target, but somehow resulted in a loss? It was probably because it took too long for your trade to play out. Every day that it takes for you to be right about your trade, you lose money.
Theta strategies help you get around this. All theta trades require at least one leg to be short. That means that all theta trades require you to be an option seller.
Being An Option Seller
When you sell an option, you collect the premium value of the contract. So if an option is trading at 1.05 per contract and you sell it, you will collect $105 at expiration.
After selling the contract, you will start seeing profits as the contract goes further out-of-the-money and/or as time passes. You will be at 100% profit once the contract expires out-of-the money.
To make the concept as simple as possible, think of it this way:
When you sell an option, you want everything to happen that you don’t want to happen when you by an option. (If you need a refresher on buying options, check out this post on buying options.)
Benefits Of Theta Strategies
In my opinion, theta strategies have way more benefits than buying options. Theta trades are generally low risk, have predictable returns, and have advantages when it comes to margin.
Here’s a deeper look into the benefits of using theta strategies:
Low Risk
Every trader dreams of low risk trades with high returns. Theta strategies give you that luxury. Just about every theta trade you place has a defined risk. That means you know exactly what your loss would be if it went completely wrong.
Sure, you could argue that almost every trade has a defined risk, but let me remind you that theta trades have an 80% chance of success. What other trades have an 80% chance of success?
Here’s an amazing feature of theta trades that no other trades offer…. You can manipulate a losing trade into a winner. Yes, you read that right- you can work with a losing trade and turn it into a winning trade.
Regular options trades don’t have this perk. Once they expire, you lose 100%. Short options can live on. Each theta strategy has its own set of adjustments that can be made to turn a loser into a winner.
Predictable Returns
Another perk of theta trades is that you get to know exactly what your maximum profit is as soon as you place a trade. This is great for those who love to hold onto a position long enough to see it turn into a loss because they aren’t sure how much more they can make.
Instead, you can calculate your maximum profit for each theta trade before you even place it. You know what to expect and you can gauge whether or not it is worth your time.
Margin Use
Theta strategies let you leverage your portfolio in magical way. The best part, it’s interest free.
Traditionally, if you want to leverage your portfolio, you’d use margin to buy shares if you didn’t have the proper cash balance. Most brokers charge at least 8% interest on all margin loans. That means a position would need to gain 8% just to break even.
Avoid that problem with theta strategies. Options will allow you to virtually control 100 shares of a stock, interest free, for a much smaller upfront cost. The average theta trade, used conservatively, produces at least 10% when max profit is reached.
A 10% return on shares using margin would end up being a 2% return. When you use options, a 10% return is a 10% return.
By now you must be eager to learn what some of these theta strategies are. So let’s get to it!
Basic Theta Strategies
While learning the basic theta strategies, you will come to realize that they require you to do the complete opposite of what you would do with regular options trading. You will be looking at everything you know about options in reverse.
We will first start by looking at covered calls and cash secured puts.
Covered Calls (CCs) And Cash Secured Puts (CSPs)
Covered calls and cash secured puts are perfect for you if you don’t like to play with money that you don’t have. They work great in cash accounts.
They get their names because you need to either own 100 shares of the stock or enough cash to buy 100 shares. I will explain this further as I describe each one.
Covered Calls (CCs)
A covered call is created by selling a call against a stock that you own at least 100 shares in.
Selling a covered call reverses the option contract. Instead of having the right to buy 100 shares of a stock at a specific price, you are selling someone else the right. You are obligated to sell someone 100 shares of the stock if the contract expires in-the-money.
Selling a covered call not only reverses the contract, it also reverses how you look to place your trade.
Here are the important things to know when selling one:
- Choose an expiration date that is more than a week away. The further away in time, the more profits you can make.
- Pick a strike that is not too far out-of-the-money. Look for a contract with a delta of at least 0.20.
- Keep in mind that the strike you choose is the price you will have to sell your shares at if the contract expires in-the-money.
- The premium of the contract at the point of sale is your maximum profit potential.
- You get to keep the premium collected whether or not the contract expires in-the-money.
You can continue utilizing this strategy until your option expires in-the-money and are forced to sell your shares.
Cash Secured Puts (CSPs)
A cash secured put is created by selling a put against a stock that you’d be able to own 100 shares of.
Selling a cash secured reverses the option contract. Instead of having the right to sell 100 shares of a stock at a specific price, you are selling someone else the right. You are obligated to buy 100 shares of the stock if the contract expires in-the-money.
Selling a cash secured put not only reverses the contract, it also reverses how you look to place your trade.
Here are the important things to know when selling one:
- Choose an expiration date that is more than a week away. The further away in time, the more profit you can make.
- Pick a strike that is not too far out-of-the-money. Look for a contract with a delta of at least 0.20.
- Keep in mind that the strike you choose is the price you will have to buy 100 shares at if the contract expires in-the-money.
- The premium of the contract at the point of sale is your maximum profit potential.
- You get to keep the premium collected whether or not the contract expires in-the-money.
You can continue utilizing this strategy until your option expires in-the-money and are forced to buy 100 shares.
Wheel Strategy (Triple Income Strategy)
The wheel strategy, also known as the triple income strategy, is used by many theta traders. It’s one of the most used strategies because of its flexibility.
This strategy, when used properly, allows you to avoid taking losses on previous theta trades gone wrong. More specifically, the wheel strategy will help you avoid losses on cash secured puts that expire in-the-money.
These are the core steps of the wheel strategy:
- Sell a cash secured put.
- Get assigned 100 shares.
- Sell a covered call at a strike above your trade price.
- Get your 100 shares called away.
- Repeat.
See the simplicity of this strategy? All you’re doing is alternating between selling cash secured puts and covered calls. No matter what happens to your trades, you are collecting premium. You can’t lose with this strategy unless the fundamentals of the stock completely reverse.
The wheel strategy is a pure income generating machine! Check out this post for a more in-depth guide on using the wheel strategy.
That’s really all there is to the basic theta strategies. It’s time to move onto the more advanced theta strategies.
Advanced Theta Strategies
You’re probably wondering what could possibly be better than selling covered calls and cash secured puts.
Answer- bigger profits.
Yes, bigger profits means more risk. That is always the case with the stock market. The good news is that the increase in risk is not that significant and your risk is known with these advanced theta strategies.
Keep reading if you want to know how to get bigger profits with your theta trades.
Naked Calls and Puts
Selling naked calls and puts is similar to selling covered calls and cash secured puts. The key difference is that you do not own 100 shares of the stock or you do not have enough free capital to buy 100 shares. They are “naked” because you do not have the collateral to put up in the case that your positions expire in-the-money.
Margin is used for these types of plays. The buying power requirement is significantly reduced for your theta trades.
For example, selling a cash secured put at a strike price of 100 with a premium of 1.00 would require you to have $9,900 available. Selling a naked put would only require you to have $1,000 available.
Theoretically, by selling naked puts, you could sell 9 contracts and collect $900 in premium if you had $10,000 available. That would increase your rate of return from 1% to 9%!
The above scenario was only to exaggerate the benefit of selling naked calls and puts. You should never trade so aggressively.
Risks Of Selling Naked Calls And Puts
You should know already that margin requirements change as the underlying moves. Most theta traders recommend to never use more than 50% of your buying power. Using only half of your buying power usually gives you a decent cushion incase the stock experiences wild swings.
There are some very important risk factors that you must know before selling naked calls and puts:
- You can’t take assignment on these trades because you do not have the proper capital available.
- The wheel strategy can’t be used to escape loses with this theta strategy.
- Escaping loses require you to make adjustments to your naked option.
- The most common adjustment is to create a rolling order to move to a further out expiration, collect more premium, and to lower your strike.
- There may come a point where you can no longer roll to receive a credit or lower your strike.
As you can see, with naked options, there may be times that you have no choice but to close out a position for a loss. It’s okay- it happens to everyone at some point. Especially when it comes to selling naked calls….
Selling naked calls can result in infinite losses! Yes, you read that right….infinite losses. It is because selling a naked call is like taking on a short position. A short position loses as a stock increases in price. We all know that stocks can have crazy, wild rallies to insane prices *cough* TSLA *cough*.
There is no telling how high a stock will go. But when you sell a naked put, you know that your maximum risk is the stock going to zero. Of course this is not something you want, but at least you know your losses will be capped.
Moral of the story- selling naked options need active management.
Credit Spreads
People tend to get themselves into a lot of trouble with credit spreads. Not because credit spreads are risky, but because most traders don’t understand how they work.
Credit spreads are like selling naked calls and puts, but with insurance. The insurance component of the credit spreads caps your max loss. In other words, credit spreads are a defined risk theta strategy.
Let’s first take a look at how credit spreads are created:
- Sell an option
- Buy an option
The purpose of buying an option is to cap your max loss. Your max loss is the width of the strikes minus the premium received.
Its not rocket science to understand why it works that way:
When both options expire in-the-money, they exercise against each other.
Example:
Let’s use a put credit spread in an example: you sell a put with a strike of 100 for a credit of 1.00 and then buy a put with a strike of 95 for a debit of 0.50.
Your max profit is the credit received minus the debit: (1.00 – 0.50) x 100 = $50
Your max loss is the width of the strikes minus the credit received: (100 – 95 – 0.50) x 100 = $450
If you’re still confused on how the max loss works- look at it in terms of how option contracts work. Your short option will require you to buy 100 shares at 100 if the contract expires in-the-money. Your long option will give you the right to sell 100 shares at 95 if the contract expires in-the-money. You still get to keep the credit received no matter what happens.
So how does this help you? Let’s say the stock plummets to 10. If you didn’t have that long put at 95, you would be at a $8,950 loss…. I don’t know about you, but I’d take a $450 loss over an $8,950 loss any day!
Don’t Over-Leverage
Just because your max loss is smaller, it doesn’t mean that you should sell more credit spreads. That would be silly. Let’s say that since your max loss is $450, but since you wouldn’t mind risking the full $10,000, you sell a lot more credit spreads.
What did that accomplish?
All you did was make it so that the stock only needs to fall to 95 for you to lose $10,000 instead of it needing to fall to 0 for you to lose $10,000 (that’s if you had only sold a naked put).
The purpose of using credit spreads is to cap your max loss if you are worried about a violent market swing moving the stock against you. Credit spreads are a great option if you want to sell calls on a stock.
Short Strangles
Short strangles are perfect to use on rangebound stocks. You can increase your profit potential by selling both a naked call and a naked put together.
If a stock is trading in a range between 80 and 90, then you would sell a put at 75 for 1.00 and sell a call at 95 for 1.00. Your total premium collected is 2.00 (or $200).
Selling just a put or a call would have netted you only 1.00 in premium (or $100). Why only sell one and not the other if you know the stock is rangebound? Is it because you think your buying requirement will be higher?
Your buying requirement will be the same!
More Premium For The Same Cost
The beauty of this theta strategy is that your buying requirement is the same as if you were selling one and not the other. Why? Your broker is well aware that only one contract can expire in-the-money. So why would they require you to put up collateral for both of the positions?
Risk Of Using Short Strangles
Once one side of the short strangle is breached, it carries the same risks associated with naked options. If the call side of the short strangle is breached, the losses could be infinite. If the put side of the short strangle is breached, the max loss would be if the stock went to zero.
Iron Condors
This theta strategy should be easy to grasp after reading about credit spreads and short strangers. The reason for that is because an iron condor is a short strangle that is made with a combination of credit spreads.
You’d be surprised by how many traders use iron condors without realizing that it is just a short strangle using credit spreads.
Instead of selling both a naked call and a naked put, you sell a call credit spread and a put credit spread.
Since iron condors don’t really need that much explaining, I’ll just go ahead and list the benefits of using an iron condor:
- The ability to play a stock that is rangebound.
- More premium collected with the same buying power requirement.
- Have defined risk on both sides of the short strangle.
You’d use iron condors if you wanted to collect double the premium on a rangebound stock and wanted to have a defined risk theta play.
You Now Know All Of The Most Common Theta Strategies
Now that you know all of the most common theta strategies, you can go ahead and start collecting premium! These strategies aren’t hard to understand or execute.
You can’t beat these theta strategies!
If you want to learn more about theta strategies, you can go visit the Theta Strategies section of this site.
Did you like this post? What is your favorite theta strategy? What do you use for your theta trades? Make sure to let me know!