Theta Gang Bible

(taken from the thetagang sub wiki)


What is this place? What is theta gang?

/r/thetagang is a sub for traders who are interested in selling options.

An option? What’s that?

Options are derivative financial instruments, which means they derive their value from an underlying, such a stock or commodity. Options are a contract in which the buyer has the right but not the obligation to buy or sell the underlying at an agreed upon price on or by a certain date.

All options have an expiration date after which they stop trading. Because they eventually expire they are also wasting assets, which means they lose extrinsic value as time passes. This is where theta gang comes in.

Uh huh… I don’t really understand anything you just said, but I’m curious, why would anyone want to trade options?

There are two main reason why someone would want to trade options: hedging and speculation.

Consider an investor who buys a stock but is worried about a price decline. They can purchase options (put contracts) to protect themselves if the stock’s price were to fall. And if they think a stock is overvalued and want to short it, they can purchase options (call contracts) to protect them should the price rise. In both cases the investor is hedging their trade because they are trying to profit from the stock and not the options.

The other reason is speculation. Options allow someone to make a directional bet on a stock without buying or selling the actual stock (the underlying).

Why would someone bother with trading options when they can just trade the underlying?

Leverage. The contract unit of an option is the amount of the underlying that the owner can buy or sell when exercised. Equity option contracts are standardized and each contract (also called a “lot”) is for 100 shares. It’s a way to have exposure to the underlying without needing the capital to buy or sell 100 shares for each contract. In other words a smaller amount of money controls a higher valued asset.

Options allow a buyer to make amazing profits. If a trade goes incredibly well, they could see profits anywhere from 100% to 10,000% (a few are even lucky enough to get 100,000%). And despite being leveraged the most amount of money they can lose is what they paid to buy the options. This is known as the premium and is paid to the seller.

The option buyer’s losses are limited to the premium and their profits are potentially unlimited, whereas for the seller the losses are potentially unlimited and the profits are limited to the premium.

WHAT?!? Why on Earth would anyone sell options with a payout like that? Especially when you could become rich so easily?

If only it were that simple.

The reality is most options expire worthless. If you buy options not only do you have to get the directional bet right, but you have to get the timing right as well.

If you buy a stock and it goes nowhere for a while and then suddenly takes off in price, you make money from this trade. Not necessarily for options. They eventually expire and if the stock soars after the option expires, tough luck. You get nothing and lose all your money.

All of the incredible gains you see with options happen because the underlying made a huge move in a relatively short period. In other words, you have to take an immense amount of risk to make a boatload of money. It’s far more likely that the options expire worthless and you lose everything.

And if getting the direction and timing right wasn’t hard enough, it gets even worse. Options are priced to lose. Recall that options are a wasting asset. An option slowly loses extrinsic value as time passes. This is referred to as theta decay. If the underlying doesn’t move in price fast enough (in the right direction, of course) to offset the loss in theta, you lose money.

This leads to an interesting outcome: an options buyer can be right and still lose money, and an options seller can be wrong and still make money.

WHAT?!?! How can someone be wrong in a trade and still make money?

The value an option has can be split into two parts: intrinsic and extrinsic.

Remember how options have an agreed upon price to trade the underlying at? That’s called the strike price. As an example, if a call option has a strike of $10, and the stock is trading at $10.50, the option has $0.50 of intrinsic value.

The extrinsic value is also known as the time value of an option. It’s the risk premium the seller receives for taking on the risk of selling options. Using the same example as earlier, if the option is trading for $1.10, the extrinsic value is $0.60.

The intrinsic and extrinsic value combined are the option’s premium, and the seller receives this premium in full. So if at the date of the option’s expiration the stock is trading at $10.70, the option is worth $0.70. The seller’s $0.40 profit is the buyer’s loss. And if the underlying is at $10 or less on expiration? It expires worthless and the buyer loses 100%.

This sounds too good to be true. If most options expire worthless why doesn’t everyone sell options and get rich?

If only it were that simple.

It’s true options are priced to lose and that most expire worthless. What is a wasting asset for the buyer is a wasting liability for the seller. However, it’s still a liability and sometimes that liability can end up being a real loser.

It’s not just a matter of a win/loss ratio. The magnitude of the wins vs. losses must be considered. The most an option seller can make is the premium, but they can lose far more than that if the underlying moves against them. It’s possible for a seller’s loss to be multiples of the premium they received for selling an option. If an option seller is really unfortunate, they can experience a loss on a single trade that wipes out months of profits.

There’s no easy money to be made trading options.

The Greeks

This section is a brief overview of the Greeks with an emphasis on the seller’s perspective.


Delta has multiple meanings:

  1. How much the option’s price changes relative to a change in the underlying’s price.
  2. The option’s equivalent of a position in the underlying (a directional bet).
  3. The probability the option expires in-the-money (moneyness describes the relationship between the strike price and the underlying’s spot price, or the distance between spot and strike).

Definition #2 is important to understand when making delta neutral bets (discussed later). These profit from a decrease in volatility along with collecting theta. It’s possible to construct a trade where a movement in the underlying does not change the position’s value (or by much).

Definition #3 is an approximation. Many option sellers like to sell out-of-the-money options with a delta of 0.30, which means they have an approximately 30% chance of expiring ITM.


Delta is not a constant. An option’s delta changes as the underlying’s price changes. Gamma measures how much delta changes relative to a change in the underlying’s price. Option buyers have positive gamma, whereas sellers have negative gamma.

Gamma is highest at-the-money. As expiration approaches gamma increases for ATM options and decreases for ITM and OTM options. On expiration day gamma can cause delta to rapidly change from zero to one (or zero to minus one) and vice versa for ATM options, since there’s very little time left to expire ITM.

Gamma is also affected by volatility. Options with higher volatility have lower gamma ATM, and ITM and OTM strikes have higher gamma compared to ITM and OTM strikes of options with lower volatility.

Long (positive) gamma works in favor of the buyer. As the underlying moves further ITM, gamma increases delta and profits accelerate. As the underlying moves further out-of-the-money, gamma decreases delta and losses decelerate.

Short (negative) gamma works against the seller. As the underlying moves further ITM, gamma increases delta and losses accelerate. As the underlying moves further OTM, gamma decreases delta and profits decelerate.

Gamma is bad news for sellers. Theta gang has always been at war with gamma gang. Gamma is also the reason that delta hedging is so difficult when it comes to being delta neutral.


Beloved theta. The namesake of /r/thetagang. It’s why we’re here all here and why you’re reading this.

Theta represents the time value of an option. It’s the extrinsic value of an option, and as each day ticks away the time value decreases a little. That amount is determined by theta. Theta decay is nonlinear and accelerates as expiration approaches for ATM options. ITM and OTM theta decay tends to be more linear.

The goal of an option seller is to profit from collecting theta. One could sell an option that’s ITM and profit from the underlying moving OTM, but that’s not a theta bet, that’s a directional bet. ITM options also have less time value than ATM options. ATM options have the most time value and so the most theta to collect, but are at a greater risk of expiring ITM compared to OTM options.

The more days to expiration an option has the slower the theta decay. 30-45 DTE is a very popular period to sell. Others prefer weeklies.


Vega measures how much an option’s price changes relative to a change in implied volatility. Vega is highest for ATM options and decreases the further strike prices are from the underlying’s price. The more DTE an option has the greater the vega.

The IV of an option is the market’s estimate of how volatile the underlying will be in the future. The higher the IV the greater the time value of an option, which means options with higher IVs are more expensive. Option buyers want to buy when volatility is low because options are cheaper. Sellers want to sell when volatility is high because options are more expensive.

The best time to sell options is during the gut-wrenching periods when no one wants to sell because volatility is so high (such as the March 2020 crash). Options become extremely expensive and there are juicy premiums to collect. Look for large spikes in IV.


Vomma (or volga, either term being a portmanteau for volatility gamma) is a much lesser known Greek (and also not nearly as important as the others). It measures how much an option’s vega changes as the implied volatility changes.

OTM options have the most vomma. This detail will be discussed later in a horror story of option selling gone wrong.


Rho measures how much an option’s price changes as the risk-free interest rate changes.

No one cares about rho anymore thanks to interest rates being stuck at rock bottom for over a decade.


What are some basic details about volatility that are important to know?

Both option buyers and sellers care about volatility (at least they should). Buyers want to purchase when IV is low and sellers want to sell when IV is high.

An option’s IV in isolation does not actually tell you if IV is high or low. It must be compared to the historical IV for that option. Two popular methods are IV rank and IV percentile.

For example, if options on XYZ have an IV of 35% and options on ABC have an IV of 45%, on the surface ABC has higher IV. But if XYZ has an IV rank of 75% and ABC only 40%, XYZ’s IV is actually higher relative to its historical IV and may be better suited for selling.

There are different ways of measuring volatility and it’s important to not mix them up:

  • Historical volatility: This is how volatile the underlying actually was. It doesn’t tell you anything about the future volatility of the underlying. This is also called realized volatility.
  • Implied volatility: This is the market’s prediction of how volatile the underlying will be in the future. It could be greater than, less than, or about the same as the historical volatility. It’s only an estimate and can easily be wrong.
  • Historical implied volatility: This is simply the IV of an option over time. When you’re looking at historical data and overlay HV with HIV, you can see how right or wrong the market was estimating future volatility.
  • Implied volatility rank : IV rank tells you how high or low current IV is relative to HIV. It’s calculated over a period of 52 weeks. The formula is 100 * (current IV - 52 week low IV) / (52 week high IV - 52 week low IV).
  • Implied volatility percentile: This tells you the percentage of time HIV has been lower than current IV. The formula is # of days with lower IV than today / # of trading days in a year (252 is normally used).

What is volatility skew?

To understand what volatility skew is we have to go back to the 1970s.

You may have heard of a theoretical options pricing model called the Black-Scholes or Black-Scholes-Merton model. This model was published in 1973 and became very popular. It was widely adopted in the options market.

The original Black-Scholes model predicts that the IV curve is flat among the various strike prices with the same expiration. It didn’t matter if the strike price was OTM, ATM, or ITM, they all had the same IV.

IV stayed this way until the stock market crash of 1987, where the DJIA dropped 22.6% in a single day. This single event changed the options market forever. The IV curve was no longer flat but instead demonstrated a volatility smile (conceptual graph). Strike prices further from ATM started trading at higher IVs, resulting in a vertical skew.

The crash was a gut punch to investors that taught them extreme moves in markets were more common than you would expect, and options started being priced accordingly. But the volatility smile is not symmetrical, it’s actually skewed.

OTM puts have a higher IV than OTM calls. This is due to markets falling much faster than they rise (they take the escalator up and the elevator down). This causes more demand for OTM puts to protect long portfolio positions. Most investors are long the market, and some will sell covered calls which increases the supply for OTM calls.

Note that this is true for equity markets. Commodity markets behave differently. Normally there is a floor in commodity prices (although for commodities with storage or delivery constraints, as we learned in April 2020 they can dip below zero) and IV is higher for OTM calls compared to puts, because commodities can suddenly spike in price due to supply-side shocks.

In equity markets IV is inversely correlated with price, that is, IV rises when prices fall (reverse or negative skew). This isn’t necessarily true for commodities where rising prices can mean an increase in IV (forward or positive skew). Stated more generally, if lower strikes have higher IVs they have reverse (or negative) skew, and if higher strikes have higher IVs they have forward (or positive) skew.

There is also a horizontal skew, which means that for a given strike price, there can be different IVs depending on the expiration date. This is the term structure of volatility and can be plotted on a graph. If the curve is upward sloping (short-term has lower IV than long-term), then it’s expected that IV will rise over time (short-term IV rising) and it’s typically a bull market. If the curve is downward sloping (short-term has higher IV than long-term), then it’s expected that IV will fall over time (short-term IV falling) and it’s typically a bear market.

The story of James “Rogue Wave” Cordier of A tragic lesson in how not to sell options

James Cordier is a former money manager who has the dubious honor of not only losing all the money of his clients by selling options, but even leaving them with a debt because the losses were so staggering.

James was a proponent of selling options and had even written a book about it. He had a now defunct website,, which targeted individuals with a high net worth. His strategy was simple: he was selling naked options on crude oil and natural gas. For years he made he made his clients plenty of money. Things were great. Until they weren’t… and the results were catastrophic. His clients lost everything and even owed money to their broker, INTL FCStone. Where did James go so wrong?

James was selling naked strangles on natural gas and crude oil. In November 2018, both markets moved against him, but the real losses came from his naked natgas calls. He sent an email with the subject line “Catastrophic Loss Event” to his clients on November 15th, dropping the bombshell that not only was all their money gone, but they may be facing a negative balance.

If you look at a chart of natgas you can see why his accounts blew up. Natgas experienced a huge spike in November and his broker liquidated their positions at an absolutely massive loss.

What mistakes did he make and what can we learn from them?

Picking up pennies in front of a steamroller

Part of his strategy involved selling deep OTM naked calls on natgas (call leg of short strangles). Deep OTM options typically don’t sell for very much, so in order to collect more money you sell a bunch of them to make it worth the trade.

This is a terrible idea and no one should ever sell a bunch of deep OTM naked options. It can work great for years, until one day it blows up your account. In order to collect a decent premium you have to overleverage yourself. This is extremely risky and you will eventually experience a major loss one day. The odds are not in your favor.

The underlying does not even need to cross the strike price for you to lose money. The underlying’s price simply needs to move significantly closer to the strike price and you’ll be deep in the red. This is made even worse if volatility spikes, which increases the option’s price and your losses (discussed in detail in the next point).

Notice what happened the following months: natgas prices crashed back to what they were before the spike. Had James not overleveraged his positions, he could’ve ridden the losses out to a profit. In fact, all those options probably would’ve expired worthless.

There is another reason not to sell many deep OTM naked options. Imagine you’re a speculator with a small account (e.g., /r/wallstreetbets). They want to trade but they can’t afford to buy ATM or slightly OTM options, so what do they do? Buy deep OTM options, bidding the price up. When a market moves big and the small-time speculators want to trade it, all they can afford are the cheap options, which are deep OTM. This is bad news when you’re short them.

Not understanding the relationship between price and volatility

Recall that for commodities volatility can be positively correlated with price. Natgas is one such commodity, and when the price spiked so did volatility. James did not understand the consequences of this.

When you are short options, you have negative vega. Volatility spiked alongside with price, and the short vega position piled up his losses in addition to being short delta.

But vega is not a constant. We finally get to discuss vomma now. Vomma measures how much an option’s vega changes as IV changes. In other words, as IV increases, so does vega thanks to vomma. Remember which options have the highest vomma? That’s right, OTM. So as IV increased, not only did his losses increase due to rising IV, but vega itself started increasing thanks to vomma, further accelerating his losses.

He got wrecked four different ways: being on the wrong side of delta, gamma adding to delta, being on the wrong side of vega, and vomma adding to vega.

A total absence of risk management

Risk management is essential when it comes to trading, and selling options is no exception. Selling naked options can expose you to extreme risks, and to ignore it is simply reckless. It’s more important to avoid a huge loss than to make a huge profit, because all it takes is one big loss on a trade to make recovering from it impossible, ending your career in theta gang.

Tail risk is a very real concern in trading, and those “rare” events actually happen more frequently than traders expect (fat tails). Look at a price chart of natgas over the past twenty years. You can see random spikes sprinkled throughout the chart. James never stopped to think, what would happen to the value of my positions if natgas were to suddenly spike in price, which I know has happened in the past, and will happen again someday? How could I protect myself against this scenario?

It’s pretty obvious that if a one-day or even few weeks move manages to blow up your account and completely undo years of profits, you have zero risk management in place. This stems from not understanding how the natgas market works, and trading it with no regard to risk.

Selling naked calls on natgas is a terrible strategy because natgas can have sudden price spikes, and IV will spike with it. A much better strategy would’ve been selling a call backspread. You sell an ATM or OTM call, and you buy two or more calls that are further OTM. That way if natgas did spike your losses are limited, and you might even turn a profit on the spike.

Spend the time necessary to learn about the underlying. And don’t neglect risk management. If you’re going to sell options, you absolutely must understand how the underlying behaves and its relationship with volatility, otherwise you cannot have proper risk controls in place.


What are some popular option selling strategies?

The most popular would be covered calls and cash secured puts.

CCs involve selling OTM calls on a stock you own. The short call position is covered by owning the underlying, hence the name (opposite of naked). A single equity options contract is for 100 shares, so an investor sells one call for every 100 shares they own. If the stock price rises beyond the strike price, the seller keeps the premium, but the options will get exercised and the shares called away. They sell them at the strike price, missing out on the extra gains beyond the strike. The seller still makes money on the sale, just not as much as they would have if they sold them at market price. If the stock grinds sideways, the options expire worthless. And if the stock falls in price, the options will also expire worthless, but the seller will lose money on their long stock position. Chances are they will lose more money than the premium they collected from selling the CCs.

A CSP is a naked put that’s sold either ATM or OTM with enough money in the account to cover the stock purchase if the option gets exercised. If the stock grinds sideways or rises in price, the puts expire worthless. However, if the stock falls in price the options will get exercised, and the seller will be forced to buy the stock from the options buyer at the strike price, most likely suffering a loss greater than the premium they received.

A CC has the same downside risk as a naked put. If the stock declines in either scenario the investor risks losing far more money than the premium received. If you are comfortable with the risk of selling CCs you should also be comfortable with the risk of selling CSPs. However, you can lose more money in the CSP scenario if you buy back the put before expiration if IV rises enough, vs. holding it to expiration.

Selling a CSP always means selling a naked put. It is not a covered put because you have cash to buy the stock. Whether or not you have enough money in the account to buy the shares at the strike price is irrelevant. A CP means you are also short the underlying, hence it is covered. It’s the same idea as a CC, except it has unlimited risk due to there being no theoretical limit the price the stock could increase to, whereas a long stock position can’t go below zero (not a guarantee for certain commodities).


Other common strategies are wheeling and volatility crush.

The wheel is similar to selling a strangle but not quite the same. You sell CSPs on a stock you wouldn’t be opposed to owning, and in the unfortunate case of being assigned, you then sell CCs to recoup your losses. If you’ve been selling CSPs for a while you may still be net up when assigned, but if the stock craters you’re looking at a significant loss. You hope the stock slowly climbs while selling CCs, but if the stock suddenly spikes your shares may get called away and you miss out on recovering your losses on the upside.

There are variations to the wheel before being assigned. A jade lizard is selling an OTM call spread where the max loss on it is less than the premium collected from selling the CSP. Ideally the stock will trade in between the short put and call strikes and all options expire worthless. You can also trade a ratio put spread instead of just a put.

The volatility crush trade is a delta neutral strategy. It profits not from a change in the underlying’s price, but from IV decreasing. It’s very popular right before earnings. IV on a stock can spike just before an earnings report is released due to uncertainty (vol rush or IV expansion). Unless you have insider information, you can only guess what the results will be. After the report is released, IV crashes because the uncertainty is gone (vol crush or IV contraction). Everyone knows the results.

You find a company who’s about to report earnings and the IV on their options has spiked. You then sell expensive ATM calls, and because ATM options have a delta of about 0.5 you buy 50 shares for every call sold. Your net delta is zero (delta neutral) because you’ve offset the negative delta from the short call position by buying shares which gives you positive delta. By hedging your delta you’ve eliminated directional risk. After earnings are released, IV craters and you buy back the options at a cheaper price and sell your shares.

In theory this sounds like an easy way to profit. In reality it’s not due to our archnemesis gamma gang. Delta is not a constant and as the underlying’s price changes so does delta. If the stock soars after earnings, the call option’s delta will increase and your delta exposure will become increasingly negative as the stock rises in price. If the stock tanks, your delta exposure will become increasing positive as the stock falls in price. In either scenario you start losing money from your changing delta position, and the amount you make from IV decreasing must be greater, otherwise you lose money overall on the trade.

You can try to nudge your delta in a direction to hedge against this. If you’re bullish on the stock you can overweight your exposure and buy more shares so that you have a positive delta. If you’re bearish you can underweight your exposure and buy fewer shares so that you have a negative delta. If you’re correct, good news for you. But if you’re wrong, you lose more money than if you were delta neutral.

Then you have a plethora of spread trades, such as vertical, horizontal, diagonal, and ratio, some with creative names. There are far too many to cover in this guide in detail. All of them have at least two legs (each leg is a component of the options trade) to the trade where you are both long and short options.

How does assignment work?

There are two main types of exercise styles: European and American. European options can be exercised only on the expiration date. American options can be exercised at any time before (and of course on) the expiration date.

When an option is exercised, the Options Clearing Corporation randomly selects a member firm that is short the option, and the firm uses an exchange-approved method to select a customer that is short the option. The OCC processes all assignments after market close, and because it processes closing buys before assignments, there is no possibility of assignment if you buy back your short position during the day’s trading hours.

An option buyer can exercise their option even if it makes no sense financially and they would lose money. It’s their right to do so and you are obligated to fulfill it if assigned. An option being OTM does not cancel that right, so even if an option expires worthless it can still be exercised (some exchanges have products where contrarian instructions are prohibited, but they are the exception). The buyer may be speculating that major news gets released after hours (some options trade until 4:15 PM ET) and when the market opens again the underlying has moved favorably and their gamble paid off. In fact, sometimes a stock can move significantly after hours and options that previously expired worthless are now ITM and can still be exercised (the deadline to exercise is 5:30 PM ET). To avoid risking this scenario simply close out the day of expiration.

Only about 7% of options get exercised and the majority occur close to expiration. This is because options still have extrinsic value before they expire, and once exercised the buyer loses the extrinsic value. It makes more sense for them to sell it.

Be aware that if you are assigned you may see a large negative balance or buying power in your account. This may be because the underlying stock trade has not settled yet. It normally takes T + 2 (trade date plus two business days) to settle. Settlement means an exchange of money and securities. Payment is made from the buyer’s account to the seller’s, and the seller’s securities are transferred to the buyer’s account. The other reason would be the value of the new stock position. If you have a small account and are now long or short hundreds or thousands of shares, the market value could far exceed the cash value of your account. You’ll be forced to close out by your broker. Once either the trade settles or you close out the large negative balance disappears.

If you’re assigned on your short calls and they’re naked, you will end up being short stock. Shorting stock has borrowing costs involved, separate from paying any dividends on it to the buyer. Some stocks are known as hard-to-borrow, which can make shorting a stock very expensive. In extreme cases, if a stock is HTB and you’re short, you could wind up paying thousands of dollars in borrowing fees daily just to hold the short position. Always check what the borrowing costs of a stock are before going short.

What are some scenarios I can expect assignment, especially early assignment?

If an option expires ITM you can expect it to be exercised. Unless instructed otherwise, the OCC will automatically exercise any option that expires at least $0.01 ITM.

Deep ITM options about to expire are candidates for being exercised. They start behaving like the stock itself since there’s zero real chance of them not expiring ITM. They have no extrinsic value and in fact may trade slightly below their intrinsic value (at a discount to parity, parity being the intrinsic value). This is because no one really has any incentive to trade the option anymore, especially when they could trade the stock instead, which has more liquidity. A market maker would agree to buy it at a discount and at the same time open a position on the stock and exercise the option, profiting from the discount arbitrage. For example, XYZ is trading at $50, and a 45 call is trading at $4.95. A MM buys the call while simultaneously shorting 100 shares, exercises the option and collects the risk-free profit of $0.05:

(50 - 45) - 4.95 = 0.05

Selling spreads is a very common theta gang strategy, so let’s examine the case of early assignment and assignment after expiration.

You sold a 50/55 vertical call spread for $1.40 on XYZ that’s trading at $53. It expires in a few days but for whatever reason the buyer decided to exercise early and you were assigned. You’re now short 100 shares at $50 while still long the 55 call. Because vertical spreads are defined risk trades, this isn’t a big deal. You’re still long the 55 call, so you have upside protection which will cap your losses at $360 (500-140) should the stock move past $55. You could take the risk of riding it out and hoping the stock falls or you can close out the trade, accept your losses and move on.

The other scenario is assignment at expiration. This is actually the more dangerous case of the two. Imagine the same circumstances except it’s expiration day (Friday). The stock closes at $53, the short call expires ITM, and the long call expires worthless. The short call is exercised and you’re assigned. Because you no longer have upside protection anymore, this is not a defined risk trade but instead undefined. You’re short the stock over the weekend and no one knows what the opening price will be Monday (gap risk). If major news gets published Sunday the stock could soar. Or it could crater. This is not the kind of risk theta gang likes to take. You should always close out of your short options on the day of expiration if there’s a real chance of them expiring ITM, especially when your long options will expire OTM. Otherwise at that point you’re now delta gang.

Be forewarned that if you’re short a spread and both legs expire worthless, and the underlying moves so that both are now ITM, your broker will not automatically exercise your long option for you. Any automatic exercise occurs based on the close price, and an option can move from OTM at close to ITM during after hours trading. Not only that, but brokers do not receive assignment notices until after the window to exercise has closed. If you’re ever in these circumstances, you have to manually instruct your broker to exercise, and they may have an earlier cutoff than 5:30 PM ET. If you don’t, you may wake up to a very nasty surprise assignment and loss the next trading day.

If both the short and long options are ITM at expiration, the most you can lose is the spread minus the premium received. You might as well close out to avoid the hassle of being assigned and exercising your long options.

Exercising an option early discards the extrinsic value, so normally this is never done and instead the owner sells it. But there are exceptions. The specter of early assignment gets raised quite a bit around the time dividends are paid. The scenarios are different for calls and puts.

You may have read that if the time value of an ITM call is less than the dividend, the call is at risk of being exercised early. This is not because the investor will make money from exercising. Let’s illustrate with an example. To be paid a dividend you must own the stock before the ex-dividend date. Call owners do not receive dividends. If you buy the shares on or after the ex-date you won’t be paid the dividend, so the call owner will exercise it the day before the ex-date.

XYZ is trading at $50, and a 45 call is trading for $5.25. It’s paying a $1 dividend and the ex-date is tomorrow so the buyer exercises the call. They’re now long XYZ at $45. The ex-date arrives, the dividend is paid, and the stock is discounted by the amount of the dividend, and is trading at $49. They sell and wind up losing $0.25. What happened? Simply add up the numbers:

(49 - 45) + 1 - 5.25 = -0.25

Whenever you exercise an option you throw away the extrinsic value. It doesn’t matter how large the dividend is, since the stock’s price is discounted by it on the ex-date. This is a losing trade. The only way the trade could make money is if the stock isn’t discounted by the full amount. Sometimes this happens (other news gets published) but this is nothing more than a gamble if attempted. It’s not an arbitrage opportunity.

In fact, as the ex-date approaches you may see ITM call options trading at parity. This occurs because the stock’s price will be discounted by the dividend, and so the option’s intrinsic value will decrease as well. Buyers don’t want to be left holding it going into the ex-date because they’re going to lose money, so the selling pressure drives down the option’s price to parity.

If the corresponding put with the same strike price as the call is trading for a price less than the dividend minus interest, then the call would be exercised and you would be assigned early. The trader long the call would exercise their call and buy the put, since this has the effect of recreating the same trade, except they receive the dividend.

It’s actually ITM puts that offer a dividend arbitrage opportunity if the time value is less than the dividend. Using the example from earlier, a 55 put is trading at $5.25. You buy 100 shares of the stock at $50. Ex-date arrives, the stock is discounted to $49. You exercise the put, selling the stock for $55, collect the $1 dividend and profit a risk-free $0.75. Add up the numbers again:

(55 - 50) + 1 - 5.25 = 0.75

You may already be guessing what happens to ITM puts as the ex-date approaches. Their price increases due to buying pressure, since the option’s intrinsic value is about to increase by the dividend’s amount. Once the time value at least matches the dividend the arbitrage opportunity no longer exists.

One other scenario where you may be assigned is when the underlying is trading close to the option’s strike price on expiration day. You don’t know if it will expire ITM or not. This is called pin risk. What should you do if you’re short? Close out. It’s not worth the risk if the underlying moves adversely after market close and the options are now ITM. Just close out.

Should I close out of a position after collecting most of the premium earlier than expected?

This is a good idea. A lot of people follow a rule where if they’ve collected at least 50-80% of the premium they close out of the trade and move on to the next. They especially follow the rule when it happens much sooner than expected.

Collecting the last tiny bit of premium isn’t worth what you’re risking (a relatively large amount of money to make a small amount). You’re picking up pennies in front of a steamroller. What will happen one day is the underlying will make a dramatic adverse move, eliminating all of your profit and even putting you at a loss. You’ll be cursing yourself for being greedy and not closing out earlier.

A lot of brokers will even let you close out of a short options trade for no commission if you can buy it back for only five or ten cents.

My position moved against me. What can I do about it?

You have a few choices.

1. Close out

Close the trade. Accept your losses and move on. How do you decide if it’s a good idea to close? Ask yourself, if you didn’t already have this position would you do it now? Would you open the position now given the current price and market circumstances? If not, close out.

You’re going to end up on the wrong side of trades sometimes. It happens to everyone. Sometimes closing out is the right idea. Other times it’s not. You can’t predict the future, so don’t beat yourself up when you make the wrong decision. But always be mindful of risk management and keep your losses small.

2. Ride it out

It’s not unusual for option prices to spike only to collapse in price later on. If you haven’t overleveraged yourself you have the funds available to ride out the trade. If the answer to the earlier question about opening the trade now is yes, it’s reasonable to ride it out. You might even consider selling more contracts, but remember to never overleverage.

Just make sure the HAPI (hope and pray index) isn’t high, otherwise it’s a sign you should close out.

3. Roll

Rolling is a good idea when you think the trade in the short term is a bad idea, but long term will make money. You close out of your existing position and open a new one. This is ideally done simultaneously so you don’t trade into the position one leg at a time, risking a poorer fill on price (slippage) or only getting only a partial execution and your positions are now wrong.

Rolling up is rolling to a higher strike price. Rolling down is rolling to a lower strike price. And rolling out or forward is rolling to a later expiration date. Typically you roll out, and possibly up or down. Whatever you decide, the goal is to roll to a new position that you can sell for more than the loss on the old position. That way you can at least recover your losses, and if you’re fortunate, still turn a profit.

I’m doing great! I’m winning on all my trades collecting that sweet, sweet, theta. I want to sell even MOAR!

Slow down there, speed racer.

The second worst thing that happens to new traders is they have a series of winning trades (the worst being they lose all their money). They become overconfident, think they have it all figured out, and place a trade that’s way too big for their account. They of course don’t realize how clueless they are, discover to their horror the trade was completely wrong, and end up digging through the remains of their now smoldering account.

You’ve made a bunch of winning trades. Great. Don’t let it go to your head. Don’t start scaling up massively simply because you’ve been winning lately. A better strategy is to risk a fixed percentage (e.g., 1-2%) of your account on each trade. As you make more money the dollar value of each trade increases but the percentage stays the same. That way when a trade ends up being a loser, which will happen, the damage is minor and you can still recover.

Theta gang is not a get-rich-quick scheme. If you’re going to commit to this you’re going to be doing it long-term, which means slowly making money.

I like to sell options on stock indices like the S&P 500. Anything I should know?

SPY is extremely popular for trading options but there is a much better alternative: SPX. Why?

  • Contract size: Both SPY and SPX options are for 100 shares, but SPX trades the full price of the S&P, so ten SPY contracts equal the notional value of one SPX contract. This cuts down commission costs by a factor of ten.
  • Cash settlement: SPX is cash settled so your account is either credited or debited and you never have to deal with any shares of the underlying.
  • No risk of early assignment: SPX is European style so there’s no possibility of early assignment.
  • No dividends: You never have to worry about dividend risk with SPX.
  • Favorable tax treatment: SPX options are 1256 contracts, which means they have different tax treatment. It does not matter how long you hold 1256 contracts for, whether less than a minute or over a year, all trades are taxed the same: 60% of gains are treated as long-term and 40% short-term. Theta gang trades are almost always short term (one year or less), so this is the biggest reason why you should trade SPX over SPY. You’ll get to keep more of your profits.
  • Minis are available: If you want to trade SPX options but don’t have enough money, fear not. XSP is 1/10th the size of SPX, so it’s the same size as SPY but has all of the benefits of SPX. The only downside is it’s not as liquid.

The Nasdaq-100 counterpart is NDX, and Russell 2000 is RUT.

If you like to trade options on commodities, you should consider futures options. Both futures and futures options are 1256 contracts and receive favorable tax treatment.

Should I place market orders when trading options?

Only if the options are very liquid and the bid/ask spread is narrow. SPY is an example of excellent liquidity. Others have a spread so wide you could drive a truck through it. You’re better off placing a limit order at the spread’s mid-price. Often times it will get filled, and if it doesn’t you can adjust the price closer to the bid or ask until it does.

Are there any good books to read?

“Trading Option Greeks” by Dan Passarelli is an excellent book to read about options theory and trading. It’s only 330 pages and covers the basics of options, the Greeks, strategies, volatility and various examples of it in different market conditions. It’s a great read.

“Options as a Strategic Investment” by Lawrence McMillan is also another solid choice, but it’s really long (1,000 pages). Might be better as a reference (reading only what you’re interested in) rather than reading it completely through.

“Option Volatility and Pricing” by Sheldon Natenberg is another great book, a little long at over 500 pages, but be forewarned that it goes over the theory in detail and the math may be hard to understand. If more advanced math is impenetrable to you, you probably won’t get as much out of it compared to the other books.

Any parting advice?

As much as theta gang hates to hear it, there are good times to be an options buyer. If you were long deep OTM puts on SPX before the March 2020 crash, you’re not reading this because you’re too busy sailing on your megayacht that’s stuffed to the gills with hookers and blow.

If you think it’s an opportune time to buy options, don’t be hesitant to do it just because you’re a seller most of the time. Sometimes being a buyer is absolutely the right thing to do, and it can pay off way more than selling ever could for a single trade.

WTF do all these acronyms mean?

Acronym Meaning
ATM At-the-money
BTC Buy to close
BTO Buy to open
CC Covered call
CCS Call credit spread
CP Covered put
CS Credit spread
CSP Cash secured put
DTE Days to expiration
GTC Good ‘til canceled
HTB Hard-to-borrow
HV Historical volatility
IC Iron condor
ITM In-the-money
IV Implied volatility
MM Market maker
OI Open interest
OTM Out-of-the-money
PCS Put credit spread
PMCC Poor man’s covered call
PMCP Poor man’s covered put
STC Sell to close
STO Sell to open

Thank you so much for this very informative post.

1 Like

This is great ! Very helpful !