Last week's article discussed basic ideas about theta, the Greek that tells us how much our options trades decay or benefit from the passage of time. Those newbies who need a review can find it at this link.

Many new options traders tend to start out buying long calls or puts, positions that are negative-theta positions. Those options decay with the passage of time. Without enough price movement in the right direction to offset that decay (or a big rise in implied volatilities), the option will lose more money each day due to that decay. The decay will speed up as expiration approaches. Debit call or put spreads, spreads in which the trader purchases a call or put and sells a further-out call or put, are also negative-theta positions, but the selling of the further-out option tempers the rate of decay.

Many option traders eventually gravitate to strategies that sell the more expensive, closer-in options and buy the further-out ones. Such trades include iron condors, butterflies, and credit spreads. These are typically established as positive-theta trades. They benefit from the passage of time, and the trader wants those more expensive option to decay in value. Often--but not always--such positions can be established for a credit. The more decay that occurs, the more credit the options trader gets to keep when the trade is closed or expires.

OCT Iron Condor, Established for a Credit of $1.60/Contract, OptionNet Explorer Chart:

At initiation, this trade had a theta of +9.56. It would theoretically benefit $9.56 from the passage of a day's time, if implied volatilities and price stayed the same.

An Iron Condor with Price about to Move Outside the Expiration Breakevens:

Notice that as the price approaches an expiration breakeven in an established iron condor, this position's theta has gone negative. This position is no longer benefitting from the passage of time. Not only is price movement working against this position; but also, theta is. The options trader who holds this position has other ways of knowing that this trade is going wrong, of course. The 38-percent unrealized loss would be a big clue! On this software, the red profit-and-loss line for the day would tell the trader that not only is the trade underwater; but also, it's past the maximum preset loss that the trader intended to take.

One reason an option trader chooses this trade is to benefit from the passage of time. Price movement outside the expiration breakevens can change that nature of the trade, one of the primary reasons that it would be established. Traders who want to hang on to a losing trade because they can't stand the thought of closing it and locking in a loss are now in a trade that violates every reason for establishing it in the first place.

That's bad enough if the trader is aware of the negative theta and hangs on anyway, perhaps out of a belief that it's got to turn around sometime. Even experienced traders employing much more complex trades than a single butterfly or calendar trade might not be aware that components of their trade now sport negative thetas. With the passage of time, these components may be detracting from the trade rather than adding to it.

Let's take the example of the butterfly trader who adjusts by adding or moving butterflies as the expiration breakeven is approached. I have known butterfly traders who add as many as two additional sets of butterflies, planning for the additional expenditure and setting aside the additional margin for the adjustments before they ever open the first butterfly. After their guidelines have been met for adding those additional butterflies, they stop adding additional butterflies and move the furthest-out one when an adjustment is needed. Let's look at the example of a hypothetical two-contract ATM SPX put butterfly first established by selling wings 70 points out, with a simulated open on June 24. The trader who plans to add two sets of butterflies as an adjustment, in steps, each time the expiration breakeven is approached, would plan for an eventual six contracts of flies.

Original Butterfly:

By July 5, a relentless climb had meant the SPX price had approached the upside breakeven of this trade, necessitating the addition of two more flies according to our hypothetical trader's guidelines. Then the price had again approached the upside breakeven, necessitating a third set of two butterflies, added on July 5.

Resultant Trade, Full Allotment of Added Butterflies:

The rally remains relentless, however. Within a few days after this chart was snapped, it would have been time to make another decision. If the trader had plenty of money set aside, why not go on adding butterflies indefinitely? After all, at some time, price might reverse and those lower flies would plump up in value again.

There might be something else to consider. Let's isolate that original butterfly and see how it's performing on July 11, as price continues to move higher.

Original Butterfly, Time Moved Forward to July 11:

We see that, no matter how much this component might produce if SPX prices reverse, what's certain now is that it's bleeding premium. The negative theta shows that it's going to bleed more premium every day that passes without that reversal.

I don't personally know of any traders who have more than three tranches on at one time, although there may be such traders, of course. This isolation of the original fly shows why most traders would likely choose to move the further-out fly rather than just keep adding flies. This fly isn't adding anything to the trade.

As I always do, I want to note that this was not a trade suggestion. Nor is the adjustment method the one that I currently use, although I have in the past when market conditions were different. This setup was chosen for illustrative purposes only, and a trader considering this adjustment method should back test it thoroughly first.

The takeaway? If you're trading complex trades, isolate the components now and then and determine if they're all still working the way you expected them to work when you established the trade.