Understanding Theta, A Key To Options Profit And Loss

Yesterday, a friend asked me a question about options that perplexed him. I’ll paraphrase for the sake of clarity and anonymity:

On October 19th, when Zoom (ZM) was trading at $580, I thought that price was nuts.I bought the $300 puts expiring on Jan 15th, 2021 for $4.91.Yesterday the stock closed at $351, down about $230, but the puts closed at $3.10.I was right that the stock would plunge, but with the stock down ~40% my puts are down ~37%.How did I lose money on this trade?

Allow me to add for background that my friend is hardly a neophyte or uninformed investor. He’s a successful entrepreneur with a Wharton undergraduate degree. Unfortunately, he made an all-too-common misunderstanding for options traders. He focused on one “Greek” – delta – at the expense of another – theta. Let’s use the following snapshot of ZM options taken today using the “OptionTrader” function of my IB Trader Workstation. Please pay particular attention to the at money, $350 options as well as the out of the money $300 puts that my friend mentioned. For the sake of simplicity, I removed most of the available columns aside from basic pricing data, delta, and theta.

(Click on image to enlarge)

Delta is the most straightforward options pricing variable to understand. It is the price change of an option for a given change in the underlying instrument, all things being equal. In the case of US equity options, that is expressed in dollar increments. If a call option has a delta of .5, we can expect that the price of the option will increase by 50 cents if the underlying stock rises by $1.The reverse is true for puts. This is a fairly easy concept for investors to understand. 

Stock investors typically think in terms of delta whether they realize it or not. Stocks go up and down, and investors know that options tend to follow those stock moves. Much of the recent popularity of options is attributable to the understanding that options can provide an inexpensive, risk-controlled method for tracking the moves of a given stock or ETF. During the relentless rise of the market and many popular stocks, many savvy speculators realized that they could supercharge their returns by buying call options on those stocks instead of the stocks themselves. Their potential loss was limited to the initial options premium paid (and any associated commissions), while their gain was theoretically unlimited. That structure was especially appealing to gamblers who gravitated to markets when spectator sports were largely shut. A relatively small outlay could have a high return, there was a multitude of potential outcomes on which to wager, and best yet, the sheer number of speculators on one side of the market could actually influence the outcome of the contest – something that is impossible for bettors in other fair contests. (I wrote about this distinction at length here).

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Disclosure: The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the ...

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