Theta changes at an exponential rate. In English, that means that the time value of any options you’re holding will decay more quickly the closer those options are to expiration. If you’re an option buyer, that means you want the move in the underlying to happen sooner rather than later, because even if you’re right about the direction of an underlying, those long calls you bought last month might still be losers even if your stock makes a big move today, because once you’re close to expiration there will be very little time premium left in those calls.
Conversely, if you’re an options seller, it might seem pretty intuitive to say that since theta accrues more quickly near expiration, you should just sit on your hands until the Tuesday before expiration, and then go out and sell the heck out of every option you can find.
However, from a risk management perspective, that last view is dead wrong. The reason, while not at all obvious, is absolutely crucial: as expiration gets closer, the risk posed by extreme amounts of gamma outweighs the theta you’re collecting. Remember, the point of options selling (whether in the form of vertical spreads, iron condors, or whatever) is to profit from the passage of time and changes in volatility, not from taking huge directional risks. But when you’re playing with lots of negative gamma, your deltas start to flip around and move out of control, such that it becomes very difficult to control your deltas and therefore your directional exposure.
Instead – and we know this may be counter-intuitive – try selling spreads with 4, 5, or more weeks left before expiration. Diversifying across multiple months and multiple strike prices is a great way to avoid getting stuck with evil negative gammas. Only Mugatu trades options spreads near expiration.
[tags] options, trading, gamma, theta, expiration, volatility [/tags]