what a trade could
is anyone’s guess.
For a realistic re-
turn on capital that
doesn’t depend on
a stock’s direction,
like theta, which
measures an op-
tion’s sensitivity to
time decay. In an options trade, theta is how
much total credit you receive less transaction
costs (positive theta) or the debit you paid
(negative theta) over time, all things being
equal. Because time is constant, looking at
return on capital based on theta can help you
balance positions as you might for delta and
For example, say a trade that makes an
estimated $10 of positive theta every day and
requires $1,000 in capital has a lower return
on capital than a trade making $10 of positive
theta every day that requires only $500 of capital. Is it a perfect metric? No. But it lets you
compare apples to apples, like beta-weighted
delta. But unlike deltas, which need to be beta-weighted before you can add them together
for your portfolio, you can simply add the theta of individual positions together to get a total
theta. (One day passing is the same for every
position, and theta is expressed as the dollar
change in value, per one day passing.)
Now, capital’s theta return doesn’t mean
additional cash is generated in your account.
Here’s how a trader thinks about capital’s
theta return. She may prefer to earn a certain
percentage of her capital—say 0.01%— from
theta every day. That’s $1 of theta for every
$10,000 of capital requirement. If a short
out-of-the-money (OTM) put position, for
example, has a lower capital return than
she’d like, consider the components of her
calculation: theta and capital requirement.
She can’t change the short put’s theta. But
she can possibly reduce her capital requirement by turning it into a short put vertical.
To build a short-put vertical out of an existing short put, she needs to buy a further
OTM put. But which one?
On the thinkorswim platform, you’ll find
the theta of each option on the Trade page
(Figure 2). Look at the theta of your short put.
Then look for a further OTM put with a small
theta that won’t reduce the positive theta of
the short put too much, but with a strike that
isn’t too far away from the short put’s strike.
For example, if you’re short a put that has
$1.50 of positive daily theta and a capital
requirement of $20,000, its theta return on
capital is 0.008%. If you buy a put that’s 30
strikes further OTM that has a theta of $0.20,
the resulting short put vertical will have a net
theta of positive $1.30 ($1.50 – $0.20) and a
capital requirement of about $3,000. By sac-
rificing some positive theta to reduce capital
requirements, you’ve increased the position’s
theta return on capital to 0.0433%. Yes, your
potential profit is smaller. But capital’s theta
return is higher.
If a trade is tying up your capital, you prob-
ably want it to contribute in a positive way.
Having a target theta return on capital tells
a trader that each position is contributing its
fair share. Say the daily theta of your portfolio
is $559, and the total capital requirement (BP
effect) is $358,296. The portfolio’s theta re-
turn on capital is 0.156% per day. If that num-
ber is lower than your target, then you may
need to reduce capital requirements. If it’s
greater, you may need to reduce position size.
THE LOVE TRIANGLE
All these metrics—delta, capital require-
ments, and return on capital—can change
daily. As a trader, you make daily adjustments
to your overall portfolio by entering new
trades and closing existing trades. As an
investor, you might want to think of these
metrics in terms of a range—from an accept-
able low to an acceptable high. That way,
daily metrics changes can fluctuate but still
remain within your range.
Remember, position adjustments increase
commission costs, so keep an eye on how
many you make.
All these metrics are available on the
thinkorswim platform. Whatever your preferences and trading style, you can still use
overall percentages of stocks, bonds, and
cash. But within stocks and bonds, you can
add new criteria and likewise evaluate positions in terms of delta, capital requirements,
and theta return on capital. And although an
investor may not make daily portfolio adjustments, it’s worthwhile to check the portfolio’s metrics daily. All you have to do is log in.
Thomas Preston is not a representative of
TD Ameritrade. The material, views, and opinions
expressed in this article are solely those of the
author and may not be reflective of those held by
TD Ameritrade, Inc.
For more on the risks of trading and trading
options, see page 37, #1– 2.
FIGURE 1: What’s your buying power? Analyze the buying power effect of your positions so
you know which may use more capital than others. Source: thinkorswim® from TD Ameritrade. For illustrative
What’s the idea behind
“Are You Missing the
Forest for the Trades?” in
the thinkMoney archives
online at tickertape.
FIGURE 2: Watch theta. Customize the settings on your option chain from the Layout drop-down to view the theta of calls and puts. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.