Time Decay and the Gamma Slide – Why You Shouldn’t Let Your Options Expire Worthless

One of the toughest trades to make in an iron condor is the exit trade, but it’s also what tends to separate the winners and the losers.

Time Decay
Time decay is one way condors profit

The most intuitive thing to do is to let your options expire worthless. After all, this is why you started trading iron condors in the first place, right? To gain from the gradual erosion in value of out-of-the-money options.

Letting your options expire worthless is the most tempting thing to do. Not only do you gain the last few cents of the remaining value of the options, you also save on commissions as there is no commission charge for options that simply expire. However, over the long term it’s generally the wrong decision. Here’s why:


1 – The Gamma Slide

The “gamma slide” is not as much fun as it sounds. It’s a description of how your profit/loss chart looks at expiration compared to how it looks when you put the trade on. Here is the profit/loss chart of the put side of an iron condor that expires in 49 days. The white line is your profit/loss chart the day you put the trade on (today), while the red line is how the position looks on the expiration date (in 49 days time). As time progresses, the white line gradually moves until it becomes the red line.


Gamma Slide


Now imagine that the market starts moving down straight away, from 1740 down to 1680. It’s a big move, but these kind of moves can happen. It doesn’t matter how much time you have left until expiration, you are going to lose money on this move. However, if you have a lot of time left (the white line), the amount of money you lose will be smaller. If you have very little time left until expiration (e.g. if today is expiration day), then you will lose a LOT of money. Here is the same chart showing the move:


Gamma Slide


The red line shows a massive swing from profit to loss. The loss is large enough that it could wipe you out completely. The white line, however, shows only a moderate loss*. If you are on the white line, with lots of time left until expiration, you have plenty of time and capital to adjust your position. You live to fight, and profit, another day.

As a general rule, iron condor traders tend to like fairly flat profit/loss charts. However, as always, there is a tradeoff with collecting time premium.


2 – Theta decay changes with money-ness

Many option traders incorrectly state that the time decay of option value increases sharply right before expiration, i.e. that option value drops sharply in the final few days before expiration, like this:

ATM option theta decay**

ATM option decay theta

What this chart shows is that the value of an option will decay fairly slowly for most of its life, and then rapidly decay in the final few days. However, this chart shows option value decay for at-the-money options only. Iron condor traders will rarely be short at-the-money options, as most iron condor strategies require some form of adjustment before the price approaches the short options.

For out-of-the-money options the value decay chart looks very different:

OTM option theta decay**

OTM option theta decay

For out-of-the-money options, the value actually decays very slowly in the final few days. Iron condor traders generally trade out-of-the-money options, so the second theta decay chart is the one that is relevant to us.

Let’s look at some numbers from the second chart. First off, let’s realise that the option expires in 40 days. After this time, the option has a value of zero. However, after only 20 days, the option’s value has decreased from $4 down to $1. So, even though we’ve only been in the market for 50% of the time, we have collected 75% of the premium from this option. Instead of staying in this trade for another 20 days and collecting the rest of the premium, we should consider closing this trade and opening a new one. The risk/reward is greatest for us before the line starts to curve down towards zero.

So there you have it. The takeaway of this post is…

In terms of the risk/reward of an iron condor, it is more favorable to close out your soon-to-expire options and then open a new trade, rather than let your current options expire worthless

* I am ignoring the effect of the large increase in volatility for simplicity. With a shorter time to expiration, increases in volatility will cause you to lose money even faster, so the situation is even worse for soon-to-expire options than described here.

** These charts and numbers are not strictly accurate, and are instead meant to stylistically show the rough shape of the time decay of ATM vs OTM options.

The Iron Condor Explained

The iron condor is a VERY popular options strategy that you’ve probably seen advertised online by so-called “options gurus”. One of the reasons it is so popular is that the iron condor is capable of generating high returns regardless of market direction. Unfortunately the internet is littered with stories of iron condor traders who have lost everything when the market has gone against them – they did not fully understand the dangers on the iron condor, and mistakenly considered it to be a “low-risk” strategy

So, here’s a crash course on one of my favorite option strategies.


What is an Iron Condor?

An iron condor is an options strategy that involves simultaneously buying and selling multiple option contracts, such that you will make money if the underlying stock (or index) stays within a particular price range. This is what is so powerful about iron condors: they enable you to make money no matter which way the market goes.

The iron condor is made up of four distinct options (all on the same stock and the same expiration date):

1) BUY A PUT with a very low strike 2) SELL A PUT with a low strike 3) SELL A CALL with a high strike 4) BUY A CALL with an even higher strike

This gives us the following payoff diagram:IronCondorPayoff

This payoff diagram is actually an example of a real trade on the Russell 2000. In this example the Russell was at 1125 and we traded the following options:

1) BOUGHT A PUT with a strike price of 1025 for a debit of -$6.90 2) SOLD A PUT with a strike price of 1035 for a credit of +$8.10 3) SOLD A CALL with a strike price of 1200 for a credit of +$4.30 4) BOUGHT A CALL with a strike price of 1210 for a debit of -$3.20

If we add up the debits and credits from buying and selling these options, we end up with a credit of +$2.30 (which actually means +$230 dollars for our account).

A meaty condor

Now let’s consider what might happen between now and expiration. If the Russell 2000 index stays between 1035 and 1200, then all the options we traded expire worthless. This means that while we lost money on the options we bought, we made more money on the options we sold.

If the index rises above 1200, then the call we sold begins to increase in value (i.e. we lose money). However, above 1210, the amount of extra money we lose on the 1200 call is hedged by the money we start making on the 1210 call we bought.

If the index falls below 1035, then the put we sold begins to increase in value (i.e. we lose money). Once the index falls below 1025, then the put we bought begins to increase in value too, offsetting the money we are losing on the first put.

The most we can lose on this trade is -$770, which happens if the index ends up outside of our trading range of 1035 – 1200.


The Philosophy of Iron Condor Trading

While the act of trading an iron condor is very simple, the philosophy of the strategy is very different from that needed for equities trading.

Firstly, you must come to grips with the idea of selling rather than buying. You make money in iron condors primarily by selling overvalued options, and watching their value decline. The options we buy in an iron condor are simply hedges so we don’t lose too much money when things go wrong.

Secondly, when you sell options, you are actually selling two main things: volatility and time. A decrease in volatility will decrease the value of the options you sold – volatility is the key ingredient of options prices and is worth several articles in itself. In effect, we are collecting “volatility risk premium” – the difference in price between what people are willing to pay for an option, and what the option should actually be worth based on typical realized volatility. This is just like the way an insurance company makes money – people are willing to pay more for insurance than it should actually cost based on historical incidences. As time to expiration decreases,  the value of the options will also decrease. This puts the odds in our favor if nothing happens.

Thirdly, iron condors have a natural asymmetry to their return profile. If the risk is not managed appropriately, an iron condor will typically show many months of small gains, and then a very large loss. It is vital for new iron condor traders to realize this in order to manage their risk and capital appropriately.


Which Iron Condor to trade?

So by now you’ve probably already realized that there are a lot of variables involved in trading the iron condor. How you set up your condor really depends on your trading personality and risk tolerance. We’ll look at how to set up the “perfect” iron condor in the next post.