Genius Nation, welcome to another episode of The Option Genius Podcast. I am so grateful to have you here. Today we’re going to be talking about theta, but before we do that, I want to talk about holidays, because it’s kind of related to our topic. I love holidays. I mean, I love all of the holidays. You know, it’s just a day off, or maybe more than one, depending if you get the weekend involved. It’s a time to relax, and whether you’re retired or whether you’re a full-time passive trader, it’s awesome anyway, because everybody’s off. The kids are home, maybe your spouse who’s still working is home, you have relatives and friends, maybe they come over. I love holidays. There’s so many things for us to be grateful for. If you’re listening to this, I can honestly tell you that you are better off than probably 90% of the world’s population.
Holidays just give us that little extra reminder to celebrate, because I don’t celebrate enough in my life. I try to be as grateful as I can, but I should be more grateful, and I should celebrating more and enjoying life more. The holidays actually give you that little push, the remembrance, and say hey, you know what, you’re good. Go enjoy your life. Take a break from the mundane. Take a break from the day-to-day stuff. And so you go on picnics, you do outdoor stuff, and really what’s best of all for us passive traders is that the markets are closed.
Recently we just had the Labor Day holiday. We have Thanksgiving coming up pretty soon. We have the Christmas breaks coming up. Thanksgiving is actually my favorite holiday, just because it’s the one where you just set aside the day, and you just give thanks. You take out the time, and you say thank you for this and thank you for that and thank you for this and everything that you’re grateful for. It’s amazing. I love that particular holiday. But then we also have Christmas coming up and the winter breaks, and the kids will be off for weeks, and the markets will be closed, and traders will be off on holidays.
Actually, the tip I have for you, it’s kind of a secret, but I have found, going back through all the years of trading, that my best month, and I think the best month for most option sellers and most passive traders, is December. I think we do the best in December, because I think December is probably the calmest month. What I’ve found is September and October are usually the most wild, but December is the one where most stocks are pretty calm. You might have a little bit of a Santa Claus rally where the markets are just going higher, higher towards the end of the year, but that’s kind of expected. I don’t know exactly why it is, but I think it’s because most of the people on Wall Street, most of the people that work for the mutual funds and for the big investment houses and the financial planners and the investment advisers and all these traders, they’re taking time off. They’re leaving early. They’re taking the whole month off in many occasion.
If they’ve had a good month, if there’s a trading firm or there’s a mutual fund or a hedge fund or whatever that they’ve had a good year, then they’re not going to risk it the end of the year. They don’t want to mess it up, because they want to go into January saying oh, we made so much money in last year. They’re not going to take a risk in December and try to mess it up, so they lay back and they don’t trade as much and they put less money at risk, because they also know they’re going to have a lot of redemption and whatnot towards the end of the year. That’s when people put money to work and move money around, so they’re going to have to have all that stuff, and they’re wrapping it up. They’re doing all their paperwork and whatnot.
And I think really, you can take a look at the volume and the liquidity, and that goes down too in December, because there are just not that many active people in the market. There’s still people there. It’s still fine to trade, but I find that December has been, for me at least, the best month to sell options. And so if you are not selling options yet, if you’ve been listening to the podcast and I haven’t convinced you yet, haven’t got you in the market yet, this is the time to get in. Even if you don’t have real money to work, fine. Paper trade. Put some trades on. Paper trade it. If you don’t have an account that allows you to do paper trading or virtual trading, then just write it down on paper. Write the trades on paper. That’s actually what real paper trading is.
That’s a little side note. December’s coming up. Take advantage. Put your money to work if you some. Get in, get off the sidelines. Start with a little bit and then increase it as you get better. But as I said, we’re talking about the holidays. You’re probably thinking, Allen, why are you talking about the holidays? Well, because with the holidays, like I mentioned, you have days off. You have extra days off, extra days when the market is closed. Coming back to our topic of theta, we still get theta decay every day the markets are closed. Now, theta is time decay, so basically I call it the option seller’s best friend. Theta is the one option Greek that measures how much value an option will lose on a given day.
So in essence, the theta is how much money we make. If you put on a trade, an option-selling trade, you can look at it and say, how much theta is this trade? If the stock does not move that whole day, that’s how much that your trade will decay. That’s how much money you will make in your trade, because the options will be worth that much less at the end of the day. Now, theta decay, I don’t want this to be a big lecture on theta decay, but theta decay does go in a exponential curve and whatnot, and we can cover that in a later bit. But my point here is that the more theta we have, the more money we make, and when the markets are closed we still get the theta, but there is no risk, since the stock’s price is not moving. Stocks are closed, the markets are closed, there’s no even after-hours trading. There’s nothing, it’s just closed.
And the options that we sold are losing value every day. There’s a theta decay rate, there’s an amount every day that the option loses value. That sounds like we’re getting something for nothing. That’s like free money, huh? I mean, that’d be kind of pretty cool. But do we really get a free day of theta on a holiday? Kind of, not exactly. Kind of, all right? Let’s get to this.
Now, if you think about it, the weekend is the same thing, because the markets are closed, so more free money, right? We don’t even have to wait for the holidays. Every weekend we get free theta. So let’s just do this, let’s go in on Friday close to the close, sell a whole bunch of options, get the theta decay on Saturday, get the theta decay on Sunday, and then on Monday morning at the open we buy all those options back. Oh man, that’s like free money. No risk. That is a wonderful, can’t lose scenario, right?
Well, you wouldn’t be the first person to think of that. I hate to break it to you, but everybody knows that. Everybody knows about theta and the weekends. Sellers do, option buyers do. So yes, we do get the theta decay every day the markets are closed, but how much we get is the issue. And the question of how much theta you get is actually dictated by a special group of people. It’s not like the Mafia or anything. It’s nothing that sinister. So who changes the theta? Well, market makers. That’s what they’re called. That’s what they’re grouped in lump sum, market makers. These are firms, companies, and they employ people to do this work, whose job it is to get orders filled and keep the markets calm and keep transactions flowing.
These guys, they used to be on the floor of the exchanges, now they’re less and less in there. It’s all mostly computer-based. These guys, these market makers, these companies who gets paid, they get paid to do this, are the ones taking the other side of trades, because if somebody comes in with a huge sell order, I want to sell this many shares, if they can’t find enough buyers, then there’s a problem. So the market makers will step in and buy those shares, and then they will change it up and do their shenanigans and do whatever they have to do to hedge themselves, and then eventually unwind that trade. Their job is to make a market, to be the other side of somebody coming in and saying I want to do this or I want to do that. They will do the opposite.
I don’t want to get too deep into what market makers are and how they work, but for this discussion, just know that market makers are the ones that manipulate the prices of the options to take theta into account. For example, let’s say you have an option that’s worth a dollar today, and if there’s 50 cents of theta, that option should be worth 50 cents tomorrow. That’s normally how it should work. So market makers, they have their computers, they have their formulas, all that, and before, like I said, people used to do this. Now mostly computers do this. Normally what happens is on a Friday, the day before the weekend … we’ll use the weekend as an example, same thing happens on holidays … but what happens is that on Friday, the options start to lose value to make up for that two days of theta decay, Saturday and Sunday.
If you want to see this, you can do. The next Friday comes along, just take a look at option prices, look at two or three different options that you’re looking at, and then during the day, see how that value of the option changes. Now, if the stock doesn’t move at all, that would be the most perfect scenario, because you’ll actually see this. So if an option has theta decay of $1 a day, for example, and it’s worth $10 at the close on Friday, you would expect it to open on Monday at $8. It’s worth 10, loses a dollar on Saturday, loses a dollar on Sunday, on Monday it’s worth eight bucks. That’s common sense. Yeah, but then people would be able to take advantage of that. The decay is actually not that linear, not that dramatic.
So what happens is that the market makers start taking out the theta decay during the day that the option is still trading, so on Friday. Let’s say we’ve got a weekend coming up. Let’s say today is Friday morning. We have the weekend coming up. Market makers know this. They have to take out the theta decay, that’s what they have to do. And these market makers, they’re specific. There’s a market maker in one stock or another stock or a commodity, and they specialize in all these different things. So they know this, because they do it on a regular basis.
They’ll take out some of the theta decay in the morning. They’ll take out some more at lunch. They’ll take out some more by early afternoon, and then the rest of it close to the end of trading on Friday. Because otherwise, like I said, all we have to do is sell options on Friday at the close and then buy them back right away on the open on Monday for free money, with almost no risk. But you already know, right, that there is no such thing as free money. So that’s actually how they do it. They take it out little by little by little during the day before the market is closed, so that when you open up on Monday, it’s back to normal, everything is fine, all the theta is out for the weekend. It’s already been taken out before the weekend even started.
That’s the point of my episode here. The theta decay is taken out before the holiday is started, before the weekend is started, so you need to know this when you’re selling your options. If you want to take advantage of this, what do you do? Well, selling close to the close on Friday will not get you the best price. Make sense? So if you’re going to sell an option on Friday, do it in the morning, the sooner the better. Better yet, sell it on Thursday, and then take Friday off for a three-day weekend. Pretty cool, right?
So keep that in mind. Next time you’re making your trading rules or whatever, and if you say okay, I’m going to sell options on Friday, well, you need to know how the theta decay will work. You got your watch list, you got the stocks that you’re watching, you got the trades that you do over and over again. If you’re going to do a trade on Friday, you should know how that theta decay is taken out and when it’s taken out. Just monitor it, just watch it, and you’ll be able to see that value go down, the prices, the premium of the option will go down, down, down, down. Just take a look at whichever one you want to look at. If you’re selling the 10 delta one, look at the 10 delta options. If you’re looking at at the money, just look at at the money, and just see how that value changes during the day on Friday. You should be able to see this phenomenon.
And if you don’t want to worry about this, you don’t want to mess with it, then sell your options on Thursday. Now, keep in mind, though, depending how many days there are to expiration, the theta decay might not be that much over the weekend or over the holiday that you should need to worry about. Unless you’re trading thousands of contracts or whatever, it might not be a big deal, so you’ll just go in on Friday and just do it anyway. It doesn’t matter. But if it’s closer to expiration, then obviously there’ll be more theta decay every day. The more expensive your options, the more premium they have, the more theta decay they will have. And of course, the more contracts you have, the more theta decay as a dollar amount you’ll have. So you’ll want to take this into consideration. Keep an eye on it, monitor it, see it, and keep the odds in your favor.
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