Trading Theta: A Strategy Exploiting Time Decay

Abstract

This paper presents a trading strategy that takes advantage of the characteristic of Theta. Theta, known as the time value of the option, is always negative, at least in theory. The simple non-mathematical rationale is that any financial instruments lose value in the sense of time passing by. In terminology, time value of money is what we are referring to. Hence, shorting Theta and Theta alone is guaranteed to be profitable. The strategy involves three instruments – SPY, SPX and E-mini. By shorting SPY or SPX, we get a position of shorting Theta, as well as other Greeks. To gain a position of Delta, Gamma, and Vega neutral, a hedge is taken. The hedge can either be in SPY and E-mini, or SPX and E-mini. Four modules/algorithms are required to implement this strategy – contract selection, hedge contracts weight calculation, position adjustment cost calculation, daily Greek exposure and PnL calculation. The result shows the trading setting with main contracts of SPX Put and hedge contracts of SPY Put has the highest performance.

Keywords: algorithmic trading, option chain, option trading, Theta decay, time value, Greeks, hedging