Besides the Delta Dollars number of your portfolio, another good number to keep track of is your portfolio’s Theta Delta ratio, especially if you are a non-directional income-style trader.
For such strategies (the iron condor is one), we are generating profits from the positive theta as we hold the trade from day to day.
The risk is that if Delta is too big, we lose our profits whenever the market moves significantly.
Contents
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- Introduction
- Example Calculation
- Looking At Some Real Numbers
- Conclusion
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Introduction
The ratio Theta Delta tells us the potential reward we can get in relation to the risk we are taking.
We want theta to be big and Delta to be small, keeping the ratio high.
But there is such a thing as too much theta, which we will get into later.
The Theta Delta ratio of an individual trade is less useful and, at times, can even be misleading, which is why some people don’t track this metric.
If a particular trade has the price sitting on top of the beachball curve of the T+0 line, Delta can be very small or even zero.
When that happens, any value of theta will make the ratio very large.
But do you really have such a large Theta Delta ratio?
No.
It just happens that at that moment in time when Delta fell to zero, you see this unrealistically high ratio.
As the price moves, this ratio will quickly drop back to normal.
This is why a single snapshot of the ratio at a single point in time is not informative.
More informative is if you take the overall Theta Delta ratio of many trades across your entire portfolio of market-neutral trades.
(You can leave out any directional or speculative trades.)
And it is even better if you calculate the overall Theta Delta over multiple days.
Example Calculation
Suppose the trader has the following open trades (all of which are delta-neutral strategies):
Trade #1 on RUT: 6.0 theta / 0.45 delta = 13 Theta Delta
Trade #2 on RUT: 9.1 theta / 0.28 delta = 32 Theta Delta
Trade #3 on SPX: 6.16 theta / -0.35 delta = 17 Theta Delta
Trade #4 on SPX: 5.67 theta / -0.22 delta = 25.7 Theta Delta
Trade #5 on SPX: 11.3 theta / -0.85 delta = 13.3 Theta Delta
Trade #6 on SPX: 8.9 theta / -0.84 delta = 10.64 Theta Delta
Trade #7 on SPX: 577 theta / -19.34 delta = 29.83 Theta Delta
When calculating the Theta Delta ratio, we can ignore the sign of the Delta, and we assume all values of theta are positive.
Looking carefully at Trade #7, we see it has a very large theta of 577.
Why is that?
That is because this trade has only four days left till expiration, whereas the other trade has much longer days-to-expiration.
Because of this large theta, we can allow for a larger delta of -19.
The trader maintained a reasonably good Theta Delta ratio of 29.83.
Theta can be too large for the trader’s comfort level.
A large Theta always comes with a large Gamma, which causes large swings in the P&L.
Some traders are comfortable with that; others are not.
It depends.
If you add up all the theta in the above seven trades, you get 624.
The sum of all the Delta (keeping the sign of the number) gives -20.87.
Because this Delta is negative, this trader’s portfolio has a slight bearish bias.
Therefore, the portfolio’s Theta Delta ratio is 624 / 20.87 = 30.
While you might think that you can simply average the Theta Delta ratio of each individual trade, you will not get the same number mathematically.
This number will not give you an accurate picture because one bad trade can pull down the average.
It is better to take the portfolio aggregate theta divided by the portfolio’s aggregate Delta to get your portfolio’s Theta Delta ratio.
Looking at Some Real Numbers
Is that what professional option income traders really do? Yes, kind of. Or at least some of them.
Tom King is a trader who primarily trades strangles and 1-1-2’s as income strategies, plus a few other strategies.
In his YouTube videos, you can often see glimpses of his spreadsheet.
His spreadsheet tracks the aggregate theta across all his trades, the overall Delta, the percentage Theta in relation to Net Liq, the percentage Delta over Net Liq, buying power usage, etc.
During this glimpse of his spreadsheet during the first two weeks of March 2024, we see that his Delta is generally within plus or minus 0.01% to 0.05% of Net Liq.
And his theta is around 0.25% of Net Liq.
That is with a buying power usage of just slightly above half of his net liquidation value.
While he does not have a column explicitly showing the Theta Delta ratio, he kind of knows what he wants his Delta and Theta to be.
He records his portfolio theta and portfolio delta daily.
From these, we calculated his daily Theta Delta ratio, which fluctuates quite a bit (which is normal as the market moves).
Feb 29: 77.25 Theta Delta
Mar 1: 9.9 Theta Delta
Mar 4: 18.3 Theta Delta
Mar 5: 7.14 Theta Delta
Mar 6: 22.32 Theta Delta
Mar 7: 5.2 Theta Delta
Mar 8: 14.16 Theta Delta
Mar 11: 56.28 Theta Delta
Mar 12: 5.47 Theta Delta
Mar 13: 6.15 Theta Delta
Mar 14: 23.0 Theta Delta
His average daily Theta Delta ratio for these two weeks is 22.3.
Conclusion
For options income traders, the portfolio Theta Delta ratio is a good number to look at.
If this ratio is too low, it could mean that we are letting the Delta fluctuate too much and need to control our Delta within a tighter range.
As the trade gets closer to expiration, theta naturally increases, gamma increases, and Delta changes more rapidly.
Because of the increased theta, a larger delta is allowed while still maintaining a good Theta Delta ratio.
We hope you enjoyed this article on the theta delta ratio.
If you have any questions, please send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
Original source: https://optionstradingiq.com/theta-delta-ratio/