so I am going to show you the five most important pieces to the option return puzzle: five things that have completely changed the way that I [Music] trade. Hey, Jim Schs here with you guys for another crash course. Man, we are back, and this is the option returns crash course.
Over the next, I don't know, 30, 40, maybe 85 minutes, we're going to work through the five most important pieces to the option return puzzle. More importantly, we're going to work through why these are the five things that you need for consistency and sustainability in your option trading. If you hang with me all the way to the end, in the final piece, we're going to talk about what type of returns you can expect from doing all of this in the world of options.
All right, that all sounds pretty good, but with these givens, there's going to be some gotchas, as there always is. You might have to completely change the way that you approach the world of options, which brings me to the very first piece of the puzzle: prepare to make a 180° turn right now. Here's what I mean: I started trading options so many years ago the same way that almost every trader starts in the world of options: by buying options.
Whether it was long calls or long puts, almost 100% of traders start on the long side of the option contract. I mean, this makes sense because when it comes to long options, you always have the potential for effectively unlimited gains with limited risk. I mean, that's a win-win by anyone's calculation.
The problem that I experienced firsthand and that every option buyer experiences is that lying underneath the surface of these two givens are two formidable gotchas, as we are going to see when we break down this long put trade in Apple inside of the Tasty Trade platform. So here we are inside the Tasty Trade platform, and we're going to look at Apple for the purposes of this example. Right now, the markets are closed; it's actually a Sunday afternoon, and so that's kind of nice from the standpoint of looking at prices and different things.
We can examine things more easily in isolation. So right now, you've got Apple at 176. Let's say that I was bearish on Apple, and so I wanted to go the more traditional route that most traders start with, which is what we just referenced.
I'm going to go in here to the trade page; let's just say I'm looking at the May cycle with 33 days to go, and I want to buy a put to play and implement my bearish bias in the stock. So maybe I'm looking at the 170 strike put. Now, why I'm choosing this strike and what the differences are from one strike to the other, let's not get bogged down in those things right now because they don't really matter for the purposes of what we're going to work through.
So let's say I go to buy this 170 put. I click on the offer, and you can see this is a long put; I'm paying 296 for it, and it's got all the other metrics we're going to reference a couple of those here in just a minute. But if I click on the curve view and I make sure my analysis tab is highlighted, you can see you can kind of toggle that guy on and off.
If you toggle the analysis button on, then what you see is you have a nice graphical representation of what you are up against or what you have working for you with a long put. You can see if Apple goes down to, again, kind of play my bearish bias in the stock, then I could potentially make a lot of money. If I even scroll over on the screen, you can see this line is sloped upwards, so I'm making more and more and more money, as you can see that right there, here, with the maximum profit being 16.
74, and that, of course, would happen if Apple went all the way down to zero. Now, if I'm wrong, right, as we referenced a few minutes ago, my losses are capped. The most I could potentially lose is going to be the debit that I pay on the strategy, or the $22.
96. So again, this looks like a really good situation by anyone's calculation. Well, the problem—or problems, or gotchas, I should say—are going to be at least threefold in this situation.
Let's look more closely at the breakeven point on the trade. Now, again, this is the breakeven point at expiration; there are a lot more moving parts, and there are a lot more things happening in the real markets, but it makes the illustration no less valid. I'm going to essentially have to jump over the hurdle that is covering the cost of the debit that I pay before I can make money on this trade.
I'm going to need Apple to go down below 170 and jump over the cost that I paid before I start making money. Yes, I can potentially make unlimited profits. Yes, I can potentially make a ton of money on this trade, but I need to be directionally correct.
That's the first problem, because that's really, really hard to do. Okay, the second problem: look at this Theta. Now we're going to talk about Theta in just a little bit inside of this very course, but what this number essentially shows me is that every day that passes is going to cost me money.
Specifically, it looks like it's going to cost me a little more than $7, or $7 on the option price. That's going to be. .
. The hurdle that I need to jump over—in fact, it's going to mean the hurdle that I need to jump over is actually getting higher and higher and higher as time goes on. But thirdly, and this is essentially just a summary of the first two points, it really drives the message home because I need to be directionally correct to cash in on any of this profitability.
I need to jump over this negative Theta hurdle that gets higher and higher and higher as time goes on. I'm left with a very, very low probability trade. I'm left with a very, very low probability entry.
Long options are always going to be inferior probabilistic trades for you as a trader, so be ready for that. Be prepared for that if you're going to take on the long side of the option contract, or you could even consider a different approach. So if you're looking for consistent, sustainable results over time, the truth is this: you're going to have a very hard time getting there with long options.
You'll constantly be facing an uphill battle with trying to predict direction in an unpredictable market and overcoming the low probabilities that stem from time working against you. So naturally, you're probably wondering, "Alright Jim, so what's the answer? " Well, you, sir or madam, are in luck because the great thing about the options world and the options contract specifically is there are always two sides: the long side and the short side.
As we've just seen, the long side is a pretty tough go. So that begs the question: what about the short side? Well, that is where everything flips over and everything comes to life, as we're going to see by continuing with this Apple example.
Except this time, we're not going to buy that put; we're going to sell that put. All right, so here we are—same situation, still looking at Apple, same stock price; nothing has changed. We're still in the May cycle with 33 days to go.
But instead of buying this put, we are going to sell this 170 put. So if I click on this guy, click on the put to sell, and bring up the curve view with the analysis tab checked, let's look at how this situation is different. If you now look closely at what we have in front of us, you're going to see essentially the mirror image of what we had when we bought the put.
Right when I bought the put, I was faced with potentially unlimited profitability with limited risk. Well, here I'm going to effectively have the opposite: limited profitability with potentially unlimited risk, which of course is a very, very significant difference. But look at what else we have.
You have Apple at 176; look at where your break-even point is. You're collecting roughly the same as what you would have had to pay if you bought this put. Your break-even point is down around the 167 mark.
So essentially, if Apple just stays where it is and can even afford to go down a little bit, you are going to be in line to keep the credit that you collect on entry. So in other words, you don't need to be right directionally. That's a huge gimme; that is a huge gimme.
Okay, secondly, look at this Theta number. Now, again, we're going to talk more about Theta specifically inside of this course, so I'm just glossing over the basics of the basics right here. But what this number is telling me—because it's positive—is that I'm going to have time working for me.
I'm going to have time working for me to the tune of about $7 per day. So again, I don't need to be directionally correct; there’s no pressure to get the directional move right in the stock, and every day that passes works in my favor. But then thirdly, look over at this probability: we were at 27% on the long put; we are now at 73% on the short put.
The probability of profit, the probability that you make at least one penny in this trade at expiration, is 73%. That is so much more effective as a foundation when it comes to what it is that we are trying to do over time—over the long term—in our portfolios that it's really, really, really hard to ignore the power of short options. Now, is there more to consider, like managing that undefined risk and controlling your position size to defend against outlier moves?
Like knowing when to enter a short options position and when to exit a short options position? Not to mention all the things you'll need to do or want to do along the way over the life of the trade? Yes, I mean there's all that and then some.
And that's why I would encourage you, in addition to this crash course, to lean on all the other resources that are already available to you. I mean, you've got the TastyLive live show; you've got the TastyLive archives. Hey, you've even got the YouTube channel, including—shameless plug—a bunch of other crash courses that are already on the channel done by yours truly.
But when it comes to option return specifically, and consistency and sustainability with those option returns, you have to be ready to make that 180-degree turn right now. Start focusing your energies on the short side of the option contract. Now, that being said, even if being on the short side of the option contract—selling options—allows us to mitigate our directional risks and our directional exposure in the marketplace, we can't eliminate that directional exposure, which conveniently leads us right into the second episode of this crash course where we are going to talk about Delta and how Delta impacts your option returns.
That second episode starts right now. Hey, Jim SCH back with you guys inside of the option returns crash course. We just learned we were just challenged to move away from the long side of the option contract and embrace the short side of the option contract.
Doing that leads to higher probabilities and more ways to win. But in addition to that, it also allows you to minimize your directional exposure by holding smaller delta positions, so you can significantly reduce your delta, which essentially allows you to significantly reduce your reliance on market direction with short option positions. However, for a single position, you can't eliminate delta completely.
In fact, before we dissect delta and show you how it impacts your option returns, that brings me to the second piece of the option return puzzle: day-to-day delta is going to be the biggest factor impacting your returns. Now, this is not a guarantee; this is not necessarily going to happen every single day. There will certainly be days when other metrics in the return equation step up to the plate and steal the spotlight from delta.
That will happen. But, by and large, on average, you should expect delta to be the captain of the ship, so to speak, when it comes to the option returns that you're going for and the P&L on a given position day to day. All right, so now let's turn to how delta specifically impacts your option returns.
To do this, we can actually begin with a more or less textbook definition of delta. Delta measures how an option price will move when the underlying stock in question moves. Even more specifically, delta measures how the option price will move when the underlying stock moves by $1.
To really better understand how all this works, let's take a look at a few examples. So for example, let's say you have an option on McDonald's that has a delta of 30. That means that for every $1 move in McDonald's, that option position will move by 30 cents per share, or $30 in total since every option contract is always for 100 shares.
Or let's say you have an option on Microsoft that has a delta of 50. That means that for every $1 move in Microsoft, that option position will move by 50 cents per share, or $50 in total for the contract. Lastly, let's say you have an option on Tesla that has a delta of 95.
Here, that means that for every $1 move in Tesla, that option will move by 95 cents per share, so almost the same as the stock itself—$95 in total for the whole contract. Picking up right where that last example left off, deltas always range from 0 to 100. Now, they can be positive, and they can be negative; we're going to talk about that in just a couple of minutes.
But for right now, just think 0 to 100. If an option's delta is zero, that would literally mean the option price will not move when the stock moves. This can only happen at expiration.
Similarly, if an option's delta were 100, that would mean that the option would move dollar for dollar with the stock. If the stock moves by a dollar, the option moves by a dollar. This also can only happen at expiration.
Now, there will be plenty of times when option deltas get close to zero, like 3 or 5 or 10, or get close to 100, like 90, 95, or 97, before expiration. But at expiration is the only time when you will actually see a true zero or 100 delta. All right, so now we're beginning to set a foundation for delta and how it's going to impact our option returns.
Let's push this a little bit further to better understand bullish delta and bearish delta. So if you're bullish on a stock and you're using options, you will have either a long call or a short put, or some complex strategy that features long calls or short puts. With either of these, you will have a positive delta position.
This simply means that increases in the underlying stock price are beneficial for you. Here's how that plays out with a call option: If the stock price increases, then the option price will also increase. That's the general relationship between stock price changes and call option changes—they follow each other.
So if you buy a 40 delta call in Apple for $2 to establish a long call, and Apple rises by a dollar, then the option price will rise by 40 cents and now be $2. 40, ceteris paribus (all other things being equal). This helps you, of course, because when you buy options, you want the option price to rise, so you can sell it out for more than you paid for it at some point later.
With a put option, if the stock price increases, then the option price will actually decrease. This is the general relationship between stock price changes and put option changes—they move against each other. So if you sell a 25 delta put in IBM for $1.
75 to establish a short put position, and IBM rises by $1, then the option price will fall by $0. 25 and now be $1. 50, ceteris paribus.
This helps you here because when you sell options, you want the option price to fall so you can buy it back for less than you sold it for. Now, if you're bearish on a stock and you're using options, you will either have a short call or a long put, or some complex strategy that features short calls or long puts. With either of these, you will have a negative delta position, which simply means that decreases in the underlying stock price are beneficial for you.
And here's what that looks like with the same call option and put. Option relationships hold true: stock price decreases would decrease call option prices, and stock price decreases would increase put option prices. So, if you sell a 30 Delta call in IWM for $3 for your short call and IWM decreases by $1, then the option price will fall by 30 to $2.
70. Ceteris paribus, this helps you because you can now buy back the call that you sold for less than you sold it for. If instead, you buy a 20 Delta put in IWM for $4 for your long put and IWM decreases by $1, then the option price will increase by 20 to $4.
20. Ceteris paribus, this helps you because you can now sell out your put for more than you paid for it on trade entry. Of course, the opposite to all of this is also true: if you're bullish and the stock goes down, that's going to hurt your option position, and if you're bearish and the stock goes up, that's going to hurt your option position too.
All right, so that's the nuts and bolts, you know, stripped down to the chrome run-through of how Delta works in isolation. Of course, in real time, there's always a ton of other things that are impacting your option position; it's not just Delta. But from a purely Delta standpoint, as we begin to build up our foundation of understanding option returns, this is how Delta works when it comes to dollar-for-dollar movements in the underlying stock.
Now, over the life of a position—which might last days, it might last weeks, it might last months—the Delta effects are going to be cumulative over time. Here's what I mean: suppose we sold a put in Amazon for $2. 50 that has a Delta of 30.
Now, over time, Delta itself isn't static; it is dynamic, and it will move and change as market conditions move and change. But for the purposes of this illustration, let's just assume that this position's Delta stays at 30. Over time, let's say on the first day, Amazon rises by $1.
This is good for us because a short put is a bullish position, and at a Delta of 30, we know that the option price will fall by 30 cents, and it will now be $2. 20. But let's say on the second day, Amazon falls by $2.
This is not good for us and will cause the option price to increase by 60 cents, so it's now at $2. 80. Currently, we have a loss on the position.
On the third day, let's say Amazon rises by $1. 50. The Delta impact will be negative 45, bringing the option price down to $2.
35. On the fourth day, let's say Amazon rises another $2. 50, yielding a Delta impact of 75, which brings the option price all the way down to $1.
60. So, a comfortable profit at this point. Okay, another example: let's suppose we sold a call in TLT for $3 that has a Delta of 40, and again we'll assume that it stays at 40.
On the first day, TLT rises by 50 cents, which is not good for us because we're bearish on TLT with this short call. The Delta impact will be plus 20, bringing the call price up to $3. 20.
On the second day, TLT rises again by $1. 50, which has a Delta effect of plus 60, bringing the option price up to $3. 80.
So, an even bigger loss at this point. On the third day, TLT drops, giving us a little bit of relief, but only by 25 cents, which only has a Delta effect of minus 10 cents, so the option price now is $3. 70.
On the fourth day, let's say TLT rises by another $2, which will have a Delta effect of 80, so now the option price is $4. 50. So, a pretty significant loser at this point.
Now, with these two examples, the most important takeaway is to see how the Delta effects are indeed cumulative and they add up over time. Just as we referenced with our second puzzle piece, hopefully, now you can see just how impactful Delta can be on a daily basis from pretty modest moves in the underlying stocks. Sure, we had one winner and one loser in these two examples, but the stock could have just as easily chopped around over time, essentially yielding no Delta effect in the end.
A situation and a phenomenon that you might think is pretty uncommon, but it actually happens more regularly than you might think, which ends up being the perfect segue—it’s almost like this is all planned—into episode number three on Theta, which starts right now! Hey, Jim is back with you guys for the option returns crash course. So far, we've moved away from long options and we've dissected how Delta impacts option returns.
It's now time to reveal the third piece to the option return puzzle: time decay is your most reliable profit driver, and that is where another option Greek comes into play: Theta. With Delta, we saw that how much Delta the option position carries is clearly going to impact the P&L as the underlying stock moves around, with higher Deltas leading to bigger P&L swings and lower Deltas leading to smaller P&L swings. Well, here with Theta, just how impactful time might be to our P&L is going to be directly related to how much Theta we have on that position, and this is simply because that is precisely what Theta measures: how much does an option price change when time passes, usually viewed in daily increments.
Now, whether you choose to buy the option (play the long side) or sell the option (play the short side) plays a big role in determining how Theta is going to impact your P&L. Let's take a look: simply put, option prices only have two components—intrinsic. .
. Value and extrinsic value: the intrinsic value measures the inherent worth of the option, like is it giving the longs side any additional benefit for having it, and the extrinsic value measures essentially everything else, like time premium, volatility premium, interest rates, etc. Well, at expiration, the value of the option will collapse down to its intrinsic value only.
This is because when the option expires, there is no time left for any of those other factors, like time, volatility, and the like, to impact the option price. So, in other words, at expiration, the extrinsic value of an option has to be zero. Well, this conclusion directly impacts option buyers and option sellers.
When you buy an option, you are paying for this extrinsic value; you are paying for this because it is essentially what is giving you the chance to land a big score. More time or volatility are good for you as the option buyer. However, if this extrinsic value decreases over time, which it does (although, all things being equal, that is bad for you), it simply means the passage of time is working against you.
Hence, this is why long option positions have negative theta. Conversely, when you sell an option, you are collecting extrinsic value. You collect this because it is part of the credit that you pick up on order entry, and it serves as compensation for absorbing the risk that the stock will move against you.
But again, this extrinsic value will decrease over time, which is good for you. So, you have the passage of time working for you; hence, this is why short options have positive theta. Now, admittedly, I kind of glossed over the components of option pricing: intrinsic value and extrinsic value.
The reason why I did that is that if you want to take a deeper dive on option pricing specifically, there's already a crash course on the YouTube channel. It's already out there; it's already ready for you. So, I would encourage you to give that a look.
But as you can see here, with option return specifically, having the passage of time working for you is uniquely beneficial. To push this point a little bit further, by selling options and creating positive theta, this is what increases the probability of profit on these positions. We've already seen with that Apple example that you can make money without being directionally right at all because you have the power of time working for you.
Similarly, this is what decreases the probability of profit on long option positions. You have this headwind that you have to overcome; you have the negative theta, and you have time working against you. So, you have to get the directional move correct to overcome the obstacle that is in your path—that is, time working against you.
All right, so let's take a look at some profit examples with theta. Suppose you sold a put with a theta of $4. Again, remember there are always a million other things impacting an option price, but if we just isolate theta to add to our foundation, that simply means that the extrinsic value will drop by $4 per day for the entire contract, ceteris paribus.
This is 4 cents per share to match the option quote that is always given on a per-share basis. But remember, every option contract is for 100 shares, so 4 cents a share translates to $4 for the whole contract. So, if you sold the option for $2 to begin with (or $200 for the whole contract), and it was completely out of the money (meaning its price was only extrinsic value), then after the first day the price will fall to $1.
96. After the second day, it will fall to $1. 92.
After the third day, it will fall to $1. 88, and so on. Again, we're keeping theta fixed over time, even though it is indeed dynamic, just to simplify our efforts a bit.
Similarly, suppose you sold a call for $6 that has a theta of $5. After the first day, the price will be $5. 95; after the second day, the price will be $5.
90; after the third day, the price will be $5. 85; and so on and so forth. Okay, so that gives us a start to understanding how theta is impacting our option returns.
But remember, theta will be working in concert with other factors, like delta. So let's now combine what we learned from delta with what we just learned from theta and put these two together. Using our delta example from before, let's say we sell a put in Amazon for $2.
50 that has a delta of 30 but now also has a theta of 4. Using the same stock moves from the earlier delta example, let's combine delta and theta together. The first day, if Amazon rises by $1 and the extrinsic value falls by 4 cents per share from theta, this means the option price will fall 30 cents from the delta effect and 4 cents from the theta effect, yielding an option price of $2.
66. On the second day, if Amazon falls by $2, which again is not good because a short put is a bullish position with positive delta, the extrinsic value falls by another 4 cents from theta. So, the option price increases by 60 cents from the delta effect but decreases by 4 cents from the theta effect for a net result of plus 56 cents, bringing the option price up to $2.
72. Then, on the third day, if Amazon rises by $1. 50 and the extrinsic value falls by another 4 cents from theta, here the delta effect is +45 cents, and the theta effect is -4 for a net change of +41 bringing the option price up to $2.
73. So here you can see how delta and theta are working together over time to impact the option price and thus your returns. Returns now again on a day-to-day basis.
Delta is going to be the star of the show; it is going to cause bigger swings in P&L. But over time, as a premium seller on the short side of the option contract, time decay is going to be a far more reliable profit driver when it comes to your option returns. Because again, remember that the Delta effects are accumulative, and they will oftentimes cancel out as the stocks go up and the stocks go down, and they essentially don't go anywhere.
Well, the Theta effects are always cumulative too, and so they're adding up over time. It may only be 4 cents a day, or 5 cents a day, or whatever, but over time—over the course of a couple of days, a couple of weeks, a couple of months, a couple of quarters, a couple of years—these can be really, really significant drivers to your total returns. All right, so Delta has an impact on P&L; Theta has an impact on P&L.
There is one more factor that also has a significant impact on your P&L, and that is going to be Vega and volatility, and that's the next episode that's going to start right now. Hey, Jim is back with you guys for the option returns crash course. It is now time to reveal the fourth piece to the option returns puzzle.
With the first piece, we know not to buy options; we know to sell options instead. With the second piece, we know that Delta is going to have the biggest impact on our options P&L on a day-to-day basis. With the third piece, we know that time decay is actually going to be the most reliable factor to our option returns over time.
Well, here with the fourth piece, here is what we want to understand: play for volatility contraction. Why is that? Well, before we answer that question, let's back up and understand how volatility impacts option positions and option prices to begin with.
So just like Delta shows you how option prices change when the underlying stock price changes, and Theta shows you how option prices change when the passage of time changes, Vega shows you how option prices change when the implied volatility of the stock changes. Specifically, Vega measures how the option price will change when the implied volatility changes by one point. So if an option had a Vega of five, for example, that would mean that for every one point change in implied volatility for that underlying stock, the option price is going to move by 5 cents per share, or $5 for the whole contract.
If the option had a Vega of 12, now every point in implied volatility that changes is going to be worth 12 cents per share on the option price, or $12 for the whole contract. Now, just like we saw with both Delta and Theta, you're going to have positive Vega and you're going to have negative Vega. So let's dive a little deeper into this idea.
Simply put, if an option has positive Vega, that means increases in implied volatility help and decreases in implied volatility hurt. If an option has negative Vega, that means increases in implied volatility hurt and decreases in implied volatility help. And when it comes to options, the following is always true: Long options have positive Vega and short options have negative Vega.
A call or put, it doesn't matter; when you buy options, increases in implied volatility always help you because that increases the option price, so you are positive Vega when you buy options. When you sell options, decreases in implied volatility always help you because that decreases the option price, so you are negative Vega when you sell options. So how would that impact option prices specifically?
Well, let's suppose you were looking at a put option in Disney selling for $3 with a Vega of eight. Furthermore, let's say Disney has an implied volatility of 30%. Let's say implied volatility suddenly rose by 1 to 31%.
That would mean that this option would rise by 8 cents and now be selling for $3. 08. This would help anyone who bought this put because the option price is rising, which is always what option buyers want, and hurt anyone who sold this put because option sellers want option prices to fall, not rise.
Or let's say, instead, that implied volatility had suddenly dropped by 2. That would mean that this option would have fallen 16 cents and now be selling for $2. 84.
This would help anyone who sold this put again, because they want the option price to fall, and hurt anyone who bought this put because they want the option price to rise. And that is how changes to implied volatility impact the option price and begin to impact your option returns. All right, so what I want to do now is build a cumulative case using Delta, Theta, and Vega.
Let's dive in. Sticking with the same Amazon example that we've been using, you sell a 30 Delta put for $2. 50 that has a Theta of four.
Let's now also add that it has a Vega of 10, and the stock's implied volatility is 50. Again, for simplicity, we'll assume that Delta, Theta, and Vega all remain constant over time. So the first day that Amazon rises by a dollar, let's say its implied volatility also drops from 50 to 48.
So here you have a Delta effect of -3 cents, a Theta effect of -4 cents, and a Vega effect of -2 cents (10 cents per point, and the IV dropped by two points). So the new option price would be $2. 96 ($2.
50 minus the 54 from Delta, Theta, and Vega). Okay, the second day Amazon falls by $2. Let's say its implied volatility rises from 48 to 51.
So here you have a Delta effect of +60 cents. . .
Theta effect of -4 cents and a Vega effect of plus 30 cents for a net change of plus 86, bringing the option price up to $282. On the third and final day in this example, Amazon rises by $1. 50.
Let's say its implied volatility falls from 51 to 47. So here you have a Delta effect of plus 45 cents, a Theta effect of -4 cents, and a Vega effect of -4 cents for a net change of -89. This brings the option price down to $0.
93, which would mean that your profit on the position would be $2. 50 minus $0. 93 for $1.
57 per share or $157 per contract. Okay, so my hope is that you can now see how Delta, Theta, and Vega—direction, time, and volatility—impact option prices and, in turn, impact the option returns from your positions and your portfolio. Also, notice how, again in these examples, Delta was almost always, if not always, the biggest of the three.
Now, this is almost always going to be the case. This is what we referenced earlier with that second piece to the option returns puzzle, with Delta being the biggest driver on a day-to-day basis. This is not something that you're always going to see, and it will be dependent on what you're actually trading and some other factors in the market.
But most of the time, this is what you will observe: of these three metrics—Delta, Theta, Vega—Delta will be the largest and the most impactful on a day-to-day basis. Now I want to answer the question that we posed after we unveiled this piece to the option return puzzle: Why should we be playing for volatility contraction? Well, the answer is actually very, very simple.
Most of the time, market volatility is in a state of contraction; most of the time, market volatility is very stable and usually going down—like 80% of the time. So naturally, we want to be positioned to take advantage of that, right? It's very similar to what we saw with positive Theta and the passage of time.
By selling options, we are positioned to benefit from the natural tendency of volatility to contract in the marketplace. This is because when you sell options, you're negative Vega, so you are positioned to take advantage of falling volatility by taking the short side of the option contract. Now, of course, there's a lot more to this, as my seasoned traders out there will know, with implied volatility rank, volatility clustering, binary events, and all sorts of other things—not to mention just because volatility usually contracts doesn't mean it's always going to contract.
There will be times when you are going to have to manage potentially some pretty hairy positions where volatility is expanding rapidly, but those are all separate discussions for another time and many discussions we've already had in those other crash courses that I referenced that are already on the YouTube channel. But here, I wanted to stay focused on the task at hand and really build up that foundation for understanding what impacts option returns, specifically from the short side: Delta, Theta, and Vega. All right, so now it's time to get into the final piece of this puzzle, which is going to be, "What can I expect from doing all this?
" Like, I'm investing all this time, I'm investing all this effort—what types of returns can I expect by selling options and doing them the way that Tasty likes to do them? Well, let's take a look. That's going to be the final episode of the crash course that starts right now.
Hey, Jim Schultz back with you guys for episode number five—the final episode inside of the option returns crash course. So, to this point, we've talked about selling options, not buying options. We've talked about Delta's impact on option returns, we've talked about Theta's impact on option returns, and we've talked about Vega's impact on option returns.
Now, I want to reveal the final piece to the option return puzzle, and I want to answer arguably the most important question that you probably have when it comes to selling options: "What type of annual return can I expect doing this? " Now look, if you ask 10 different traders this exact same question, you are going to get 10 different answers. Some of them will be high, some of them will be low, some of them will be realistic, and some of them will be purely imaginary.
Not to mention that there are so many different factors that go into determining what a specific individual's potential is going to be when it comes to generating returns. I mean, you've got skill level, you've got experience, you've got account size, you've got schedule—there are so many different things. So, it is a very, very difficult question to answer, by and large.
But for the final piece of the option return puzzle, I think that an annual return somewhere between 10% to 18% per year is a realistic target for most traders. Now admittedly, that is almost certainly on the lower end of the spectrum when it comes to what you've likely heard is possible in the world of trading options. And just to be clear, I'm certainly not even going to pretend to be the arbiter of truth when it comes to what your potential returns could be; they could certainly be higher than this.
I’ve seen it done; you could potentially do that. But when it comes to establishing some kind of baseline, some kind of reference point for most traders to wrap their heads around to determine if this is even a worthwhile endeavor, I think a 10% to 18% range is a really realistic target for most traders. And here's specifically why I chose that range: as we've gone through in this course, you have your three main profit drivers—Delta (or Direction), Theta (or Time).
Time and Vega, or volatility, yes, interest rates, and even potentially dividends do impact option prices too. But by and large, it's going to be Delta, Theta, and Vega that really move the needle in the end. Well, taking a closer look at those three, here is what we have: Direction as a profit driver is the least reliable.
The market is unpredictable; prices are random. So, putting any stock in Delta as a profit driver in the short term is a mistake, in my view. Yes, markets move higher over time, and over the longer-term horizon, that should be factored in.
But in the 45-day cycle that we like to trade, it's too random, it's too unpredictable. So, direction doesn't factor into my range of returns at all. Volatility as a profit driver is more reliable than direction, given market volatility's tendency to contract over time most of the time.
But still, it's very difficult to quantify just how much contracting volatility will add to your returns over the course of weeks, months, and quarters, not to mention volatility doesn't always contract; it expands too, and sometimes very rapidly at that. So, for this baseline range of annual returns, volatility doesn't factor into my numbers either. But time as a profit driver—this is the most reliable of the bunch, by far!
Again, we know that extrinsic values must be zero at expiration, and we know that by selling out-of-the-money premium, we are selling options whose prices are 100% extrinsic value. So, from the moment we press "review and send" on an undefined risk option trade, time is working in our favor. That's incredibly powerful, and thanks to the TastyLive research team, it can be quantified.
So, generally speaking, we like to hold portfolio Theta at some percentage of net liquidating value, and the range that we typically target is 0. 1% of net lick to 0. 5% of net lick.
So, if we had a $10,000 portfolio, 0. 1% would be $1 of portfolio Theta, and 0. 5% would be $50 of portfolio Theta on a daily basis.
If we had a $200,000 portfolio, then 0. 1% of net lick would be $200 of portfolio Theta, and 0. 5% of net lick would be $1,000 of portfolio Theta on a daily basis.
Now, why we might choose one end of the spectrum over the other end of the spectrum is a longer discussion for another time, and you can find a ton of resources around that very question in the TastyLive archives and already on the TastyLive YouTube channel. But for now, all we need to understand is that the lower end of the spectrum—so, 0. 1% or 0.
2%—is more conservative, and the upper end of the spectrum—so, 0. 4% or 0. 5%—is a lot more aggressive.
Therefore, let's say that we held 0. 1% of net lick in portfolio Theta, and let's suppose that every single one of our trades worked out perfectly. We never took a loser and everything expired worthless—a very unrealistic outcome, but an important boundary for us to establish here.
If that happened, and we assume 360 days per year, which is a typical accounting convention, then our annual returns from Theta alone would be 0. 1% times 360 or 36% per year. And if we held 0.
2% of net lick in portfolio Theta, our annual returns would be 0. 2% times 360 or 72% per year—terrific numbers, no doubt, but unreachable and unrealistic. So, how do we use this reference point and turn this into something that is more meaningful and is more realistic?
Well, this is where the TastyLive research team comes into play. The research team has found that when following our trading approach to managing trades and taking into account both the winners and the losers that you can expect, when you do so, a reasonable expectation is that you capture 25% of the daily Theta that you hold. So, that means holding 0.
1% of net lick in daily Theta could yield a 9% annual return (25% of 36%), or holding 0. 2% of net lick in daily Theta could yield an 18% annual return (25% of 72%). And that is where my 10% to 18% range comes from.
Now, again, these numbers are conservative, and your mileage may vary. Maybe you feel like Delta does require a home in your return equation, or maybe you feel that volatility actually can be quantified when it comes to taking volatility's tendency to contract and turning that into a tangible return number, especially when you account for waiting for implied volatility ranks to spike before you sell premium. By all means, tinker with this, tweak this, make this your own.
I encourage you to do that. But still, if we stick with the 10% to 18% range, the reality is this: If you were able to earn a 15% annual return consistently selling options, then you would be absolutely crushing it! I mean, that would be 5% more than the average annual return on the S&P 500 over the last however many years, and you wouldn't be tied to the market going higher to make money.
You wouldn't require the market moving up to generate your returns; you would be able to fully customize your directional bias in your portfolio and still churn out 15% annual returns—a realistic target that I believe most traders with enough skill, experience, and understanding of the markets could achieve. That would be a wildly successful investing career by anyone's calculation. All right, so I can't believe it, but man, we are done.
The option returns crash course is now complete; you are finished! And I really, really cannot thank you guys enough. I am so humbled that so many of you take time out of your day and time out of your schedule to invest in my content.
Thank you, thank you, thank you! I really, really hope that it. .
. Brought you some value in the world of options! If I can ever help you guys in any way, please feel free to reach out to me.
You can email me at J Schultz at TastyLive. com, or we can connect on Twitter (X, whatever they call it these days) at IAMJSchultzF3. I appreciate you guys, and I will see you next time!
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