Did the recent spike in volatility have you sharpening your Thanksgiving carving knives in anticipation of some meaty profits?
If so, today's post may help you set reasonable expectations for returns in your short premium (theta collecting) portfolio.
As highlighted on a recent episode of Options Jive, short premium positions can function effectively in both low volatility and high volatility regimes. However, a couple subtle differences exist in the the degree and type of exposure across regimes.
For example, in low volatility regimes, short premium positions may be exposed to lower average losses. At the same time, these regimes can also leave a portfolio exposed to upticks in volatility.
In contrast, high volatility regimes can open positions up to more substantial potential average losses (i.e. markets are moving more), but less risk of volatility expansion (i.e. volatility decreases via mean reversion). .
If your curiosity is piqued by the above information, we encourage you to also check out a new Market Measures titled "How Much Theta is Captured."
As the title suggests, this episode explores how much of the total theta collected actually trickles down to a trader's bottom line.
In order to formulate an answer to this question, the Market Measures team designed and conducted a robust study that backtested data from the SPY, IWM, and TLT dating from 2005 to present.
The study isolated the P/L as a percent of total theta collection (theta ratio) when deploying 1 standard deviation strangles, with 45 days-to-expiration (DTE), that were held through expiration.
The slide below provides a summary view of the combined results ("combined" refers to the fact that the theta ratios of the 3 symbols were averaged for each year of results):
As outlined above in the red box, approximately 25% of the total theta collected ultimately ended up as profit in this particular study.
A chart pictured on the episode furthermore illustrates that the strategy was largely successful in each of the years examined, with the obvious exception of 2008.
Obviously, each and every trader deploys their own unique strategy, and as a result, the target percent of total theta that eventually translates to the bottom line may vary significantly.
On the other hand, if you are deploying a somewhat similar strategy to the one backtested in this study (involving SPY, IWM, and TLT), then a target rate of 25% may be a perfectly reasonable expectation.
We encourage you to watch the entire episode dedicated to this topic when your schedule allows.
If you have a sense of the amount of theta that translates into profit in your own portfolio, we hope you'll leave a comment below or reach out at email@example.com.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.