Mastering Derivatives: Rolling calls to capture time decay

Suppose you expect an underlying to move sideways in a tight range. How should you setup a position to gain from your view on the underlying? This week, we discuss how to continually roll short call position to capture gains from time decay.

Rolling theta

The speed with which an underlying move is an important factor for options, not so much for futures. That is, for options, it matters whether the underlying reaches your price target sooner than later; when the price target is achieved before expiry will not significantly affect your gains for futures. This is because an option sheds value from time decay (theta). This time decay comes from the time value of an option and is a function of an option’s time to expiry and implied volatility.

You can gain from time decay in two ways. One, with each passing day, the option is closer to expiry than the previous day. So, it will lose value. And two, time value will decline when implied volatility declines; a decline in implied volatility occurs when the underlying either moves sideways or slowly in one direction.

Suppose you expect the Nifty Index to move sideways. You could short a call option on the index, after considering two factors. One, the implied volatility must be high when you short the call. A high implied volatility means large time value of the option. Larger the time value, greater the time decay. And two, there must be some time left for expiry — shorting, say, between 10 and six days to option expiry. That way, the time value of the option is sizable; time value during the week of expiry is likely to be lower.

You can choose an immediate out-of-the-money (OTM) strike. It is important that you close the position within the two days. The objective is quickly capture gains from time decay and control losses in the event the underlying moves up and the strike becomes in-the-money (ITM). You should use the sale proceeds to buy the next immediate OTM strike. The objective is to continually roll into a new strike till the Friday (six days) before expiry. You must check the theta of the option you want to short; that is approximately the per-day gain you can expect when the underlying moves sideways.

Risk alert

A sharp jump in volatility will hurt the position, as it is short on vega and gamma

Optional reading

Shorting options is a risky strategy. The risk of loss is more than the upside potential. Besides, you must post a significant margin for your short position. So, the continual roll strategy will be meaningful only if you are confident of the sideways movement in the underlying. Note that a sharp jump in volatility will hurt the position, as it is short on vega and gamma. You can control the risk by converting the short call into a covered call. To do this, you must combine short equity calls with appropriate number of long underlying shares and short Nifty calls with long Nifty ETFs.

The author offers training programmes for individuals to manage their personal investments

COMMENT NOW