You know about Theta and over Vega.
Next, in your evolution as an options investor, learn about the relationship between the two known as the theta vega ratio.
This ratio is useful for investors Sell credit spreads and Iron condorsas higher ratios offer an additional benefit in these cases.
Where are these higher theta-vega ratios to be found?
Short term options or longer term options?
Further broke Options or closer to the money options? Higher implied volatility Options or options with lower implied volatility?
We will start with the basics and by the end you will understand why the theta-vega ratio explains the reasons for three of the iron condor rules:
- Sell in high IV
- Sell well out of the money at the 10-15 delta
- If 50% of the maximum profit has not been achieved in half the time and has not been stopped, continue until seven days before the expiry.
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The value of one Option expires over time.
Theta indicates the loss of value per unit of time.
An option holder has negative theta as the value of that option decreases over time.
The extrinsic value portion of an option must drop to zero after expiration.
An option seller makes money with it Put options at a certain price and buy it back at a lower price.
They have positive theta and the passage of time works in their favor.
The more time it takes to expire, the slower the time decrease (less theta).
The closer the options get, the faster they expire.
Vega is the measure of how much the option price changes when the implied volatility changes.
Generally, as implied volatility increases, the price of the option increases.
Option buyers will be positive Vega.
Will be good for them when implied volatility increases.
Option sellers have a negative Vega.
Will be good for them when the implied volatility decreases.
When an option expires, its price cannot change.
Therefore, Vega has to go to zero after the expiration.
High vega options mean that these option prices are more sensitive to changes in implied volatility.
Vega is greatest for at-the-money options.
And the less money you spend, the less money you have.
The reason lies in a higher extrinsic value embedded in the at-the-money options.
Vega for more dated options will be bigger.
The reason for this is that more dated options have higher external value.
There are three main components that affect option prices:
- Direction of the underlying
- Implied volatility of the option
- Over time
Option sellers take advantage of the passage of time because that part is a surefire thing.
Option sellers can bet on direction (using credit spreads) or not bet (using iron condors).
This means that volatility remains the wild card.
Option sellers want reduce implied volatility because that lowers the option prices.
However, volatility tends to increase unexpectedly (due to bad news or fear).
This is not good for option sellers.
Therefore, they see Vega as a volatility risk.
Option sellers want big theta and small vega – in absolute terms.
We ignore the positive / negative sign in the Theta Vega calculations.
Option sellers consider the “theta-vega ratio”.
The larger this ratio, the better.
A general rule of thumb for selling out-of-the-money options is a theta-vega ratio greater than 0.2.
As the implied volatility of an option increases, its outer part of the option increases.
A higher extrinsic value means it has a larger theta because more extrinsic value has to decay in the same time.
A higher extrinsic value also means a higher Vega value (higher volatility risk).
So is it better to have higher implied volatility or not?
It turns out that in general a higher IV rank is associated with higher, more favorable theta-vega ratios.
We’ll look at the numbers later.
That’s why we want Sell credit spreads and Iron condors in environments with high IV.
So far we’ve looked at selling a single option.
When we do a credit spread (sell one option and buy another option) the theta and vega effects get complicated.
We have calculated some samples of the theta-vega ratios using OptionNet Explorer historical data and found very consistently (with few exceptions) that selling further from the money resulted in better theta-vega ratios.
For this reason, we want to keep selling credit spreads and iron condors in the 10-15 Delta out of the money.
For those who want to look at the numbers, we will provide below.
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What about days to expire?
Which expiration cycles lead to better theta-vega ratios than option sellers?
Shorter dated options have faster theta decay and lower vega risk, therefore shorter dated options have a higher theta to vega ratio.
Does that also apply to spreads?
Yes it is.
Short-term iron condors have better theta-vega ratios than long-term ones.
However, short-term iron condors have a higher delta and Gamma Risk, that’s a completely different discussion.
Short-term iron condors require more active monitoring and adaptation.
So there is a happy intermediate medium that is different for every investor.
Since iron condors have more and more favorable theta-vega ratios as the expiration date approaches, we let the iron condor approach the expiration date as long as we have not met our target and stopping rules.
We close the iron condor 7 days before it expires to avoid the risk of association.
With the exception of the minor exception circled, we see other out-of-the-money iron condors having higher theta-vega ratios.
This is true in different IV environments and in different expiration cycles, as well as in stocks with different prices.
Here we see that shorter-dated iron condors have better theta-vega ratios
If we look at Facebook and Nvidia in both normal and high VIX environments, we see significantly higher, more favorable theta-vega ratios when the implied volatility is higher.
This is true regardless of the expiration time and regardless of how far the wings are from the money.
We see the same thing when we look at Microsoft when it had a high IV versus when it had a low IV.
This applies regardless of the leaf width.
Also true for strangled.
Since a more favorable Theta Vega Ratio is associated with a higher IV, some investors may consider IV as a proxy for the Theta Vega Ratio (since calculating Theta Vega can be time consuming).
We don’t see much difference in the theta-vega ratio when we vary the width of the spread in the wings.
In other words, a 20 point wide iron condor does not have a significantly better theta-vega ratio than a 5-point iron condor.
The theta-vega ratio is slightly better for the choke than for the iron condor.
Since wide iron condors behave more like choking, wider wings should theoretically lead to higher ratios.
However, the effect is negligible and mixed.
If we calculated the theta-vega ratio separately between the iron condor puts and calls, we don’t see a pattern.
Differences are likely due to random put / call skews.
Hopefully the numbers convinced you that the theta-vega ratio is better in high IV environments, in more money-free options, and in shorter-date options.
In theory, a higher theta-vega ratio should provide an additional benefit for option sellers.
The reader is encouraged to track their theta vega ratios to determine whether or not more of their winning trades are from higher theta vega ratios.
Disclaimer: The information above applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.