Papale on Olympics and Theta

Today kicks off the 2012 Summer Olympics in London.  The talk seems to be centered around Phelps in swimming (as usual), whether Jamaica’s Usain Bolt is fit and how dominating the US Basketball team will be.  These couple weeks remind me a bit of March Madness in the NCAA Basketball tournament.  There is coverage pretty much morning til night so of course a TV will be on in the background almost continuously.  So during those mentoring sessions or webinars, if I get distracted for a minute or start cheering as we are going over gamma you will understand I hope.  Not that gamma is not exciting in its own right, but the Olympics only comes around every 2 years.

The other day I was talking to a trader and he said he only liked to do out of the money credit spreads.  His reason was he liked to collect the time decay while giving himself a cushion if the market moves against him a bit.  I agree.  Credit spreads can be a nice trade for exactly that reason.  However, I pointed out that it wasn’t exactly the credit he was attracted to but the theta.  And he could collect that theta whether he was putting on a credit call spread or an equivalent debit put spread.

Let’s say the market for ABC is trading a 100 and we decide  to sell a 110-120 call spread for $2.  If the market stays below 110 we keep our $2 and we are feeling very good about our self.  The capture of the $2 was due to theta as the out of the money options went to 0 at expiration.  However if we place the equivalent trade using the puts how does that compare?  By purchasing the 110-120 debit put spread, we have the equivalent trade.  With the call spread trading for $2 we would probably purchase this spread for $8 and, like in the call spread, if the stock stays below 110 we capture our maximum profit, in this case $2.  Same as the call spread.  Hence the spread we bought for $8 has now gone to parity or $10.  The profit is due, like in the call spread, to theta.  So remember it’s not really the credit portion of the spread per se you are likely attracted to, but the theta. And theta is a function of structure, not necessarily credit.

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