In our last article, we had discussed in detail the functions of the options Delta and Gamma. In today’s article we will learn how we can incorporate gamma and theta while trading options.
The Theta Component
At the onset, we shall start with the notion that time is a unidirectional component, ie. we can only move towards the future and never roll back to the past. However, the concept of time (ϴ) in the options world is radically different than the way we perceive time in the real world. Unlike the real world, time plays dual roles in the options realm. It is negative for long options and positive for short options. The question is, how can we use this to our advantage?
The Gamma Component
As a rule of thumb, the gamma (Г) is expected to be positive for long options, while short options are expected to maintain negative gamma. It is extremely important to note that the vectors of Г and ϴ are inversely correlated to each other. This model stems from the fact that an option position will always have gamma and ϴ of opposite signs. If you have traded options, you will realize this.
Correlating The Gamma And Theta
Since option trading is a trade-off between the gamma and theta. You can either take advantage of the drift in the underlying instrument or you can use the theta decay as a tool to generate income. Therefore we can certainly use this constant to build a trading model. Ask yourself whether it is possible for an option strike to have such a large positive Г that, if nothing changes, the option will be worth more tomorrow, than it is today? While trying to solve this, keep in mind that the rate of theta decay accelerates as we get closer to expiration. Also keep in mind that the relative size of the options gamma and theta generally are inversely correlated, which implies that the gamma of specific option strikes expand as we approach the expiry date. This is also true of the theta as the rate of decay accelerates. At this point, all you need to do is watch how these two variables shift with respect to the underlying instrument.