Option Investor
Educational Article

Negating Theta Decay

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Equity options are the greatest leverage tool known to modern man. Modern men who trade, that is. They offer the greatest return on capital possible and the allure of that mathematical fact is great.

However, there is another side to this lever. Options are also the most complex to succeed with, but most of that complexity can be easily negated or eliminated. How, you say? By using them in the manner for whence they were invented, i.e. capital risk management.

Lest all you call & put buyers click away in despair, hold on partner! We're still talking speculation in here with chance to profit far greater than not by our own control. But let's just visit a few ideas about thwarting one of the worst fiends that afflict option traders: time decay.

How many of you ever bought options that went sideways to lower in value even as the underlying stock or symbol rose? Yes, my little paw is stretched up in the air as well. We've all done it or are going to do so quite soon.

Debit Spreads
Buying extra time premium is one way of negating theta decay, but not the only one. May I suggest to you that most big money pros in our field lean on debit spreads for a reason?

Debit spreads are merely directional trades that hedge off time and usually volatility premiums on a trade. It is the act of buying a call or put closer to actual current price levels while selling another call or put (respectively) one or more strikes in distance further from the money. Elementary, right? Yes it is, but why then don't more traders use them to great advantage?

1999. That was the period in time newly born traders realized options can appreciate +100% to +1,000% or more when underlying markets are flying. Up or down, calls and puts made many of us untold sums of money on pure buying & selling. But all things in life are cyclical, market action included. No longer do we see stocks posting $10 moves in a day unless it's IBM (ouch!) or similar culprit enduring reality checks that will become more common this year.

More often a stock or index will make smaller, deliberate moves before consolidating or turning course again. Jeff Bailey & Eric Utley are masters at finding those common and sometimes obscure stocks poised to move, but often times they are not high- flying picks. Solid, profitable performers but not like the days of NDX 4,000 by any means. On a side note, I just finished a new book hot off the press where the author referred to Nasdaq sessions of 150- point moves "average". Seen any of those days around here lately? I hope & pray we're both along for that ride when it comes, but our wait may be awhile.

Just as that book was written not so very long ago, so shall our memories endure. We're sure those days are right around the corner next quarter, just like Maria & ilk promise us the economic recovery and tech turnaround must be straight ahead. Is that one of the three great promises? I forget.

Soft Entries
Anyways, now that you got me off track and back on again, forward the thought. Near to medium-term future trading is probably just what Jeff & Eric do right here in OI every day: boring stocks that create interesting results in a trader's account. One excellent method for capturing these gains with minimal capital, defined risk and time value not a factor is by spreading yourself out.

(Weekly/Daily Charts: CSCO)

Mighty CSCO. My, my, from whence we have come. This one will make a nice buy & hold around $8 to $10 before we sip New Year's champagne again, but I digress. For those who follow this stock it was a lead-pipe lock short setting up for weeks and breaking down just days ago. Those who bought April puts last Friday or this Monday bagged some serious change. But what of those who got in early? What of those who cannot watch intraday action and need to time their entries a bit on the soft side?

Debit spreads. We could have bought the May 17.5 put for roughly 1.50 and sold the May 15 put for roughly 0.50 or net debit of our account for $100 even. How many of these spreads can you afford? Probably a whole bunch, and the upside return could be $250 for a +150% gain. I realize that doesn't seem very sexy to those who cashed in straight puts for several times that, but what if they bought those puts weeks ago instead? Time value would have eroded greatly by now. Meanwhile, traders who erased time value back then still have their full intrinsic value enroute and staying power on their side.

(Weekly/Daily charts: UTH)

Utility HOLDRs have been on a nice run but are now coiled into a tight wedge and ready for action. Which way? Weekly chart stochastic signals say lower. The UTH May 95/90 put debit spread is now available for 2.50 net-debit (pure math example only, not a trade suggestion!) and those who think it might break to 90 or thereabouts in the next six weeks can risk 2.50 to return 5.00 or +100% gain if correct.

Downside risk is capped at -2.50 per spread and not a penny more. Vega and Theta are eliminated. Place such a trade, go on about your life and let time take over from there. Find enough of these low-beta plays, lock out time decay and I'm willing to bet your summer trading will be a lot more fun this year than one might ever imagine.

This Saturday we'll continue the topic of methods for part-time and longer-term traders again. See you then!

Best Trading Wishes,
Austin Passamonte

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