As I rough out this article on the morning of December 29, 2011, I'm looking at a RUT FEB butterfly trade that I've had on for nine days. I put it on a bit early because I expected a couple of things to happen. I expected that when the big-money boys and girls took their holiday breaks, the ones left behind would be left with instructions to hold the fort without letting anything big happen. I expected time to pass.

Ergo, I expected some theta-related profit to accumulate while the price action maybe ping-ponged back and forth but didn't go much of anywhere. In any case, I set the butterfly up so the delta was nearly flat, so I didn't anticipate a lot of price-related angst. I was right about that. Of course, if I wasn't facing any delta-related or price-related angst, I wasn't going to accumulate gains related to price movement, either. I knew that.

I should have known better about the other suppositions, however. In the past, I've written articles that explained why neither theta nor theta-related profits increased despite the passage of nine days. If delta was relatively flat, as it was, price action wasn't going to impact the trade. If gamma was very flat, as it was, price movement wasn't going to change the delta much, and so price action wasn't going to work against the trade. Theta should have been changing, if only a little. I know some are going to argue with me that there isn't much time decay in options that far out from expiration, but hold on for a moment until I get to the discussion about ITM versus OTM options. OTM options decay differently, with a lot of decay occurring from the 60-to-30 day period.

So, if theta also wasn't changing with the passage of time, that meant one of the other parameters related to options pricing wasn't letting theta and time-related decay accumulate. That other parameter could have been volatility. I went searching to see what had happened with implied volatilities during that time.

First, let's do a little backtracking for the sake of newbies to the Greeks of options pricing. Theta tells how much price decay to expect for a given unit of time for each option. Usually that unit of time is a day. It's expressed as a negative number for options you've bought. If all other parameters stay the same, they are expected to lose that value over that passage of time. Hence, the negative number. If you've sold an option, your theta is positive. If nothing else changes as time passes, you will gain that much theta-related profit. You can buy to close that option position for less than you sold it. If you have a complex option position, that position might be negative or positive theta, depending on the type of position. Near-the-money butterflies are positive theta, meaning that the person who buys the butterfly and establishes the trade expects to benefit from the passage of time.

Except that the position didn't benefit. Jim Bittman, writing in Trading Options as a Professional explains that "the thetas of in-the-money, at-the-money, and out-of-the-money options decrease (increase in absolute value) as volatility increases" (111). So, the possibility is that although we saw the VIX and RVX declining during that period, some of the anxiety in the markets in those days around the late-December period resulted in an increase in the implied volatilitites of all or some of the options that comprised my position. That would have worked against the theta-related decay I'd hoped to see. Jim Riggio, a fund manager and veteran of Dan Sheridan's mentoring program, sometimes refers to increasing volatility as "resetting the clock" on options. An option that was a certain number of days to expiration and expected to decay at a certain rate might act more like an option two weeks further out until expiration, for example.

I'd expected market makers to start dropping values on options, pulling out the theta-related decay about midweek each week before the two late December holidays, but that wasn't happening. That may well have been due to the uncertainty in the markets. I don't see evidence of that when I look at the composite IV figure that my charting program produces for me, which shows that the composite IV's decreased during the time I was in the trade. My first supposition about what had happened might have seemed logical on the surface. However, without following through the IV's of the individual options and computing how those individual changes might have impacted the overall position's theta-related decay, I can't be sure that happened.

Something else may have been at work, too.

Because of the butterfly structure I chose (bearish butterfly with a DITM long call to protect the upside), I had created a position with a nearly flat delta, as I mentioned earlier. As expected, the price movement over the nine days I'd been in the trade hadn't hurt my overall profit-and-loss when the RUT moved from the 712.52 level at which I'd first entered the trade toward and through 740, where my upside long put was. However, that meant that the 740 long put that had been ITM at the time the trade was begun was now an OTM put that December 29 morning. The other components of the butterfly, the short 690 puts and the long 640 ones, were further OTM than they had been at the inception of the trade. Bittman features a complex table that compares the decay of ATM, OTM, and ITM options, concluding that they decay quite differently, depending on their distance from the underlying's price. "Out-of-the-money options decay more in the first half of their lives and less in the second half, whereas at-the-money options decay less initially and more as expiration approaches. Second, the further out of the money an option is, the greater the amount of time decay in the first half of its life" (67).

Because I had set the butterfly up as a bearish butterfly, and because the RUT's rally slightly above 740 that morning had changed the composition of ITM and OTM options, decay was acting differently than it would with a standard butterfly. It wasn't acting at all!

Moreover, theta -related decay of ITM, OTM, and ATM options respond differently to changes in volatility. To give a hint of the complexity, Bittman explains that "increasing volatility causes less value to erode in the first half of an out-of-the-money option's life and more in the second half" (67), the opposite of what typically occurs with OTM options. In a stable volatility environment, OTM options decay "more in the first half of their lives and less in the second half."

I'm not going to get any more complex with this as I'd probably end up tangling myself up, much less the readers. The upshot of this is that, although the price movement did not hurt my profit-and-loss because of the way I'd structured my trades, changes in volatility and/or the changing composition of ITM, ATM and OTM options was resetting my theta in ways I hadn't expected. If you don't have Bittman's book on your shelf, you might consider getting it as a reference book. It's not exactly easy reading, but it's good to pull out when you're wondering how theta might be effected by changes in volatility and other such esoteric matters. I emphasize again that you don't have to know all this off the top of your head to trade options successfully, but it sure helps to have a reference when you can't understand why a position isn't acting the way you expected it to act. Unfortunately, a family member's hospitalization prompted me to close down the position. I have, however, kept the simulated trades open on think-or-swim. As of the close Thursday, January 5, some profit was beginning to accumulate. It was up a little over $200, minus commissions. Of course, I likely would have long since adjusted.