Now that you have the rules for selling calls and puts, let's talk more about the advantage that you gain from the strike/expiration selection. As a premium seller, you make your money through time decay, measured by the option Greek "Theta." The rules outlined in Ultima are specifically designed to balance the reward and risks of theta. Let's take a closer look at this option greek.
Understanding Theta
I mentioned in a previous post that time decay is a major factor. For an option, the rate of time decay is measured by the option Greek “Theta.”
Anyone that has traded options has experienced this, particularly those who have bought options. It doesn’t take long to notice that the price of the option is falling as the price remains stable. This is a result of the window of opportunity for the stock to move is closing steadily every day. Of course, this hurts option buyers and helps option sellers.
The issue with theta for sellers is that the risk is accentuated as the option approaches expiration. The speed at which delta changes as an option moves from out-of-the-money to in-the-money is dizzying. For option sellers, this represents substantial risk. The risk is measured by the option Greek “Gamma.” One thing you should know about gamma is that it tends to move with theta. That means as theta explodes close to expiration, so does gamma.
One mistake that people make is assuming the acceleration of theta close to expiration is the same for all strike prices, but it’s not. For the low delta options that we’re targeting, the theta diminishes over time. That means the greatest time decay happens when the option has more time to expiration. The Ultima expiration and strike selection criteria were specifically designed to capitalize on a higher rate of theta decay while minimizing the gamma risk close to expiration. It’s also the reason Don closes these trades at 50% of max gain and by 23 days to expiration.
Conclusion
As you look back over the previous posts on Ultima, it has been building to this point. Understanding the distinct advantage of selling low delta options with more time to expiration provides a great balance of reward to risk. The rules to close the trade help mitigate the risk close to expiration. This approach is such a contrast to the approach that many traders take.
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