Do you ever ask yourself why is this option trade losing money? As a trading mentor I get this question frequently.
When you are in an option trading strategy there are three components to making or losing money. Price movement, volatility changes, and time decay.
First, price movement. If you are in a directional trade then you need the price to move towards the options that you bought and/or away from the options that you sold.
I think that concept is easy enough to understand. Many traders however use strategies that are “non directional”.
Strategies such as iron condors, calendar spreads and butterflies allow for some price movement in either direction, as long as it’s not too extreme.
These strategies are trying to take advantage of time decay, which we will cover in, a bit. It’s important for directional and non-directional traders to keep an eye on their position delta.
Your position delta tells you how much money your trade will make or lose with the next dollar in price movement of the underlying. You can use the Delta number to get a sense of how well an up or down move will benefit or damage your p/l in a trade.
Secondly, implied volatility changes in the options that you have positions in and will also affect your p/l. Options derive a lot of their value from implied volatility.
Implied volatility simply put, reflects the supply and demand component for each option. In times of higher volatility there can be more demand for selling or buying certain options strikes.
When the implied volatility increases it increases the value of the option. When implied volatility decreases in an option it loses its value.
Take a look at the implied volatility changes in each option position you are in from the beginning of the trade to the point where you currently are and that will inform you about how volatility has affected your p/l.
Time Decay Or Theta
Lastly, time decay or theta. Time decay reflects an options change in value based on how close it is to expiration. The closer an option is to its expiration the more value it will lose due to time decay.
If you are long these options, meaning that you purchased them, that is a negative for your position.
As each day passes on a long option position, time decay goes further against you and you are essentially paying each day to watch that part of the trade.
If you sell an option such as in the non-directional strategies, the option you sold is losing value with each day based on time decay and that is good for your position.
In mixed long and short option positions you must determine if you are net long or short time decay.
The next time you are assessing why you are winning or losing in an option strategy remember to check these three basic components of option pricing.