Theta Return on Capital: How to Pick Options — Step-by-Step Guide & Transcript

[00:02] Our style of trading depends on generating profits from theta. What does that mean? Theta is the number that measures how much an options value decays when one day passes.

[00:14] Um out of the money options decay a little bit faster closer to expiration. Options decay a little bit faster. Um and so the idea is that we can't necessarily depend on guessing the right direction of the stock or the market or

[00:29] direction of the stock or the market or volatility even, but we can depend on one day passing. And so we do a lot of our research on that. A lot of our um the trades are based on that, generating theta um in

[00:44] our option trading. So the question is what kind of returns should you be looking at based on theta and the capital you put up? Well, one of the things I want to point out and this is

[00:59] kind of uh well, it maybe it'll make the decision making a little bit easier for you about which option you want to sell. And I want to just talk about naked short puts today just because it it makes the examples simpler.

[01:12] Is that the margin requirement, the capital you you need to put up capital you you need to put up uh to sell a naked short put is based on the stock price and secondarily where the strike price

[01:26] is in relation to that stock price. Let's keep it simple. You can look at the actual formulas yourself and see how it's calculated. Not that that that complicated, but that's not the point I want to make right now. The point I want

[01:40] want to make right now. The point I want to make is that the capital requirement is based on the stock price. It's a percentage of the stock price. That's why going to a further expiration, changing

[01:54] that short naked put from one expiration to another doesn't necessarily increase the capital requirement. Volatility going higher or lower that changes the option price doesn't necessarily change the capital requirement. Let's let's

[02:10] take a look at an example and I'll show you exactly what I mean. So, I just have Comcast loaded up. Why Comcast? It's $23.50 stock. The numbers are a little bit easier to manage with lower price stocks. So, for example, for as an

[02:25] example. So, let's go into 8 days. And let's pick a round number. Let's let's create a short put at the 23 Let's let's create a short put at the 23 strike. So, short 23 put. And the buying

[02:40] power effect is $423. Now, keep in mind that number firm you use. Some are a little bit higher. But, at tasty, it's $423 and that's that

[02:54] capital requirement I mentioned minus the premium from the short put. Okay? So, it's the net impact the net impact on your available capital is is $423.

[03:09] Now, what I'm going to do is use these buttons down here. This expiration makes it really handy to test this out. I'm just going to advance this to the next just going to advance this to the next expiration from 8 days to 15 days.

[03:22] Buying power effect 422. Wait a second, it really hasn't changed much, has it? Now, it's 420. Now, it goes up to 4 421. Now, go out to another expiration, 22

[03:38] $420 for that 23 put. Go out to 29 days, $421. Okay? Let's push it even further out. 36 days, markets are a little wider, makes

[03:54] it a little bit a little bit squirlier, as they say, about how much credit you might get. But, $427 is my point. The capital requirement you put up

[04:06] doesn't really change depending on which expiration you choose. What does matter is the theta that you generate. And one of the numbers that I talk about is the theta return on capital. How much

[04:20] theta am I generating for given dollar of capital I'm using? And a benchmark that we talk about is 1/10 of a percent per day on a trade. So, let's let's use

[04:34] Um if uh if you use uh $100 of capital, 1/10 of 1% of that is 10 cents of theta

[04:46] per day. Okay? So, if I sell a naked put and the capital requirement's $100, I hope to make 10 cents a day on that. 10 cents a day, that's that's nothing. Okay, yeah, it's not a whole lot.

[04:59] Okay, yeah, it's not a whole lot. But, if you do 10 or 15 or 20 of these types of trades in a portfolio, suddenly that portfolio is generating decent returns from theta every single day. You say, "Well, Tom,

[05:13] you know, losses?" I get that. Yeah, you're going to lose some money on know, if you do 10 of these Let's Let's say 20 of these things. 20 uh short puts, each with uh point 10% of theta per day, 20 of them's going

[05:29] to give you 2% per day. Does that mean you're going to have 500% return every year? No, of course not. It's not what it means at all. It just means that your uh account is generating that in theta per day.

[05:43] per day. And if your market to market trade In other words, the directional trades. So, one trade makes money, and one one trade loses money. Up and down, back and forth, you're

[05:56] adjusting, you're you know, choosing smart strategies depending on volatility. If that all kind of comes out in a wash, or maybe a little bit negative, that theta is going to backstop. It's going

[06:12] to still continue to generate some theta to offset the losses every single day. You're going to have good days trading, bad days trading, but if you keep that theta consistent, then that can generate extra returns

[06:26] over time. That's the point. So, what's the metric I use? Well, like I said, the metric I use? Well, like I said, 0.1%. So, um you know, $100 is 10 cents a day. Maybe I sell this this 23 put here. What's the number? $427.

[06:43] So, $427 of of capital requirements, um of of capital requirements, um 0.1% of that is going to be 42 cents. Um 0.1% of that is going to be 42 cents. Um if I'm generating a $1.31

[06:57] of theta per day, uh $1.31 is about, I don't know, three times 42 cents, approximately. So, it's going to be about 0.3% per day. So, that's a good one. Let's take it down to the 22 strike. Maybe I can give

[07:12] myself a little more room. $1.13. Let's go down here to the to the 21s. Now, it's 84. Capital requirement again is about um $233, mainly because I moved the strike. Um and further out of the money options

[07:26] can have lower capital requirements. So, the theta here, that uh is going to be 20 cents a day, um is going to be the 1% 0.1% theta return on capital. So, I'm getting about four times that with this short put.

[07:40] Okay? Now, does it does that mean you're going to make that money every single day and you're going to have these massive returns every year? No, that's My point is you have this steady drumbeat of positive theta. You have

[07:56] your portfolio of options across bunch of different underlyings, different strategies, generating theta per day. Your portfolio is a theta machine.

[08:08] So, it withstands some losing trades, it adds to winning trades, and hopefully over time, that's where you're going to generate your income from, your returns generate your income from, your returns from with short option strategies. So,

[08:23] I hope this was a helpful explanation about how to look at some of these Remember, none [snorts] of this is a trade recommendation. that's that's on that's on you and you can you can choose whichever option you

[08:39] want to use to generate theta. But when you do, please do not take any But when you do, please do not take any more risk than you are comfortable with.