Everyone familiar with options trading is aware of the big dilemma: Options close to expiration cost less but expire soon. Options with more time to develop profitably cost more. How do you balance these conflicting attributes?
Trading options very close to expiration and containing little or no time value might be the most powerful form of leverage you can use. Even though expiration happens soon, there are some situations in which short-term options just make these. Three cases are the most advantageous:
1. Long calls or puts in a swing trading strategy. The long option strategy is a higher risk than many traders realize. Three out of every four options held until expiration will expire worthless, so you have to be an expert at timing to improve on those odds. If you are a swing trader and you rely on reverse signals, or if you rely on candlestick formations also indicating a strong chance for a turnaround, you probably expect to have positions open for only three to five days. In the swing trading strategy, long options are lower-risk than shorting stock and even of going long on shares. You can use long puts at the top of the swing and long calls at the bottom, drastically reducing your market risk. Options expiring in less than one month provide the best leverage, because time decay is no longer a major factor. But this idea relies on locating strong reversal signals in price, volume or momentum; and also finding equally strong confirmation.
2. Short positions for higher annualized return. When you write covered calls, longer-expiring contracts yield more cash, but on an annualized basis, your yield is always higher writing shorter-expiring short contracts. (To annualize, divide the premium by the strike; then divide the percentage by the holding period in months; finally, multiply the holding period by 12 to get the annualized yield.) Picking shorter-term short calls works just as well for ratio writes and collars. That rapid decline in time value is a huge advantage.
3. Spreads, straddles and synthetics at times of exceptionally high volatility. Any time you open up spreads, straddles or synthetic stock positions, you will include opening some short option positions. Given the more rapid time decay toward the end of the option’s life, you get higher annualized return when you use shorter expirations, especially if you also spot a spike in volatility. This tends to be very short-lived, so going short when premium are rich often produces fast profits in changes in option premium. Time decay happens very quickly during the last month before expiration, so focus on short positions within this time frame. Just as time decay is a big problem for long option positions, it is a great advantage when you are short.
It is not realistic to assume that any duration or position type is “always” positive or negative. It all depends on the strategy, the premium level, and your expectations about how the stock price is going to move within the trend, or correct after it changes in one direction too quickly.
To gain more perspective on insights to trading strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at http://tinyurl.com/aqeeops to learn more.
Michael C. Thomsett
Michael C. Thomsett is co-founded of ThomsettOptions.com, and has also written many options books including Getting Started in Options (Wiley, 9th edition, over 300,000 copies sold); and Options Trading for the Conservative Investor (FT Press, 2nd ed.). Michael lives near Nashville, Tennessee and writes fulltime. He also is an instructor of several options courses with the NY Institute of Finance.
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