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.
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.
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:
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**
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**
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.