Delta And Theta: Probability And Time Decay

Controlling portfolio volatility and reducing overall market risk while generating superior returns relative to the broader market can be achieved with options. Essential to this strategy is a blended options-based approach where 50% cash is held in conjunction with long index-based equities and an options component. Another critical element is setting the probability of success in your favor and leveraging time decay of options via Delta and Theta, respectively.

Acting with skill and caution over ~280 trades and ~13 months, generating consistent monthly income while defining risk, leveraging a minimal amount of capital, and maximizing return on capital has been the core of this options-based/beta-controlled portfolio strategy. Options allow one to generate consistent monthly income in a high probability manner in various market scenarios. Options win rate of 98% was achieved with an average ROI per winning trade of 8.0% and an overall option premium capture of 85% while outperforming the S&P 500. The performance of an options-based portfolio demonstrates the durability and resiliency of options trading to drive portfolio results with substantially less risk via a beta-controlled manner. The options-based approach circumvented September 2020, October 2020, and January 2021 sell-offs while outperforming/matching the S&P 500 over the 13-months (Figures 2-5).

Delta

Delta serves as a proxy for the probability of success at the expiration of the option contract. Thus, this value is an absolute number; thus, a negative (put side of the option chain) or positive (call side of the option chain) value is irrelevant. The interpretation of Delta is based on 1.0 less the Delta at a given strike. If the Delta is -0.14 on the put side, this translates into 1.0 - (-0.14) = 0.86; thus, a ~86% probability of the trade expires above the strike or is worthless at expiration. If the Delta is 0.20 on the call side, then this translates into 1.0 - 0.20 = 0.80, thus ~80% probability of the expiring below the strike or being worthless at expiration. Selling options near a specific Delta that is out-of-the-money places the statistical edge in your favor. Given enough trade occurrences, the probabilities will play out to reach their expected outcome. Thus, trading at a Delta of 0.15 will yield a winning trade success rate of ~85% if all trades go to expiration (Figure 1).

Figure 1 – Option chain displaying the Delta column and probability of success at each respective strike price which is utilized for trades

Theta

Theta represents time decay over the lifespan of an option contract. As an option matures into its expiration date while remaining out-of-the-money, the time value decreases as a function of time. Theta rapidly decays into the final stretch of the option lifecycle; thus, if an option is out-of-the-money and near expiration, the option's value will be worthless or near worthless. When selling options to collect premium income, Theta is always working in your favor as time evaporates and the underlying security has fewer opportunities to challenge the strike price. When time decay is nearly complete, options can be closed out to realize gains.

Results

Overall, from May 2020 through May 31st, 2021, ~280 trades were placed and closed. An options win rate of 98% was achieved with an average ROI per trade of 8.0% and an overall option premium capture of 85% while outperforming the broader market through the September 2020, October 2020, and January 2021 declines (Figures 2-5).

Figure 2 – Overall option metrics from May 2020 – May 21st, 2021

Figure 3 – Overall option metrics from May 2020 – May 21st, 2021

Figure 4 – ROI per trade over the past ~280 trades

Figure 5 – Percent premium capture per trade over the last ~280 trades

Conclusion

Coupling Delta and Theta along with skill and caution in executing options trades can control systemic portfolio risk while matching and/or generating superior returns to the S&P 500 index. Delta and Theta are key elements in a beta-controlled portfolio via a blended options-based approach where 50% cash is held in conjunction with long index-based equities and an options component.

September 2020, October 2020, and January 2021 declines reinforce why appropriate risk management is essential. An options-based approach provides a margin of safety while circumventing the impacts of drastic market moves as well as containing portfolio volatility. Delta and Theta work together to set the probability of success in your favor while leveraging time decay to your advantage.

These options-based results demonstrate the durability and resiliency of an options-based portfolio to outperform during pockets of market turbulence. To this end, cash-on-hand exposure to long positions via broad-based ETFs and options is an ideal mix to achieve the portfolio agility required to mitigate uncertainty and volatility expansion. Despite holding 50% of the portfolio in cash, superior/matching returns have been achieved relative to the S&P 500.

Thanks for reading,
The INO.com Team

Disclosure: The author holds shares in AAPL, AMZN, DIA, GOOGL, JPM, MSFT, QQQ, SPY and USO. The author has no business relationship with any companies mentioned in this article. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned.