Trading is a timing game.
And when it comes to options in particular, timing is absolutely critical.
Now you may have heard that options are fixed-time investments that expire on a specific date.
While that is true, that “fixed time” feature doesn’t have to work against you.
In fact, it can give you the flexibility to focus your trade the way you want – a flexibility you don’t have with a straight long or short equity position.
But you need to know how to handle this “fixed time” aspect, as it can make the difference between pocketing a small 15% gain and a gigantic 300% winner.
I’m going help you get this all down pat right now.
The Truth About Expiration Dates and How they Work
When you buy an option to open (“open” means to enter or start the trade), you then have the right, but are not obligated, to either buy stock from someone – a call – or sell/put stock to someone – a put.
The option has a strike price as well as an expiration date, both of which you choose.
You have some amount of control as to what expiration date you purchase, based on what expiration dates are available to you.
“Optionable stocks” are stocks offer options. On optionable stocks, there will always be expirations for the current month and the next month out. For example, we’re about to enter June. So there will be June AND August expirations. Then, options fall into whatever option cycle of which they’re a part.
|The Three Option Cycles:
JAJO: January, April, July, October
FMAN: February, May, August, November
MJSD: March, June, September, December
The standard expiration for options is the 3rd Friday of each month. There are weekly options on some of the more liquid stocks (about 300 to 325, which you can view and track through the Chicago Board Options Exchange, www.cboe.com/weeklys).
The current month and the next month will likely always be available to buy and sell. If you are looking at an option chain for a stock on the FMAN cycle and we are in August, you will likely see August and September options listed, but none for October.
There may be some options for out in January of next year and maybe even January of the year after that. What in the heck are those? Those are LEAPS, which stand for Long-term Equity AnticiPation Securities. They are pretty much the farthest-out option expiration available, out as much as three years.
The Price You Pay to Trade is Affected by Time Value
Let’s assume you’re buying an option.
The amount you pay to buy that option is called the premium. There is a whole mathematical equation/formula used to determine the premium on any given option. It’s called the Black-Scholes formula.
Don’t worry too much about it right now.
Just understand that there are two types of value: extrinsic and intrinsic. The part of the cost paid for time value is known as extrinsic value. (I’ll return to intrinsic value later.) The more time until expiration, the more time value you will pay for, because more could happen to the price or the market in that time. So again, the farther-out options are going to cost more.
Back to this fixed time investment aspect to options…
Every day that goes by in the markets gets you one day closer to expiration; one more day that time has gone by. Time WILL go by – nothing you can do about that – and that time value will come out of the premium price of the option.
That’s why it’s important to get the timing right.
The amount of money time represents is all calculated by that pricing formula and is represented in the option by the theta. So, whatever that theta amount is, it will come out of the option price daily.
The question is do you buy an option with an expiration that’s one to three years out… or do you buy one with a shorter time until expiration?
That depends on how long you expect it will take for the stock to accomplish its price move.
When You Should Consider a Longer Time Frame
|More on the Option Greeks
The components of the price of an option are known by Greek terms:
- Delta: Measures the change in the price of an option relative to the change in price of the underlying
- Gamma: Measures the change in the Delta of an option relative to the change in price of the underlying
- Theta: Measures the change in price of an option with respect to a change in its time to expiration
- Vega: Measures the change in the price of an option relative to each one-point change in implied volatility
These are all calculated dynamically, and the end result is the premium price you see on your options chain screens.
The goal is for the stock to move in your direction so the Delta value and the Gamma values offset that Theta decay and your option becomes a higher value.
This gets a little complex so for now let’s just focus on time value, or Theta. (If you’re especially interested in this, you can read up on option Greeks in “The Index Trading Course,” the book I co-wrote with George Fontanills in 2006.)
If you think it will take a couple of years for the stock to get going, then consider buying the LEAPS on it, as it will be cheaper than buying the stock outright.
If the stock goes up in price, the option should as well. It will do so on both the longer and shorter term options, but it will move up faster on the shorter-term options because of the effects delta and gamma have on it.
The farther out in time you go, the slower the option will increase, compared to a shorter-term option. That makes sense if you think of it like this: You are taking on more risk by having a shorter time frame for the option to go up in value, so your reward opportunity reflects that.
On the longer-term option, the time value will decay more slowly. That is one benefit of the LEAP. You can see the difference in the option chain image of the LEAP on MasterCard Inc. (NYSE:MA) below compared to its shorter-term option.
LEAPS option on MasterCard Inc. (NYSE:MA)
The one option Greek or component that works against all options traders is time or Theta decay. As stated, Theta isn’t hurting you as much on a LEAP compared to shorter-term options.
Theta in the LEAP is much less than that in the September expiration – the one that expires next month.
Next-month option on MasterCard Inc. (NYSE:MA)
But here’s the tradeoff…
When You Should Consider a Shorter Time Frame
While the Theta works against you if you’re a shorter-term option trader, the Delta and Gamma work for you, especially the more the option is in-the-money (ITM) or has what’s known as intrinsic value.
Let’s take a second to look at that.
For a call option, when the stock price is higher than the strike price of the option you own, that is an in-the-money (ITM) call. The right to buy the stock at a lower price (strike price) than the current market price has a built-in value and that is also priced into the premium.
If you have an ITM option and a far out expiration, those are usually the more expensive options, because there’s intrinsic value AND extrinsic value.
Here’s Your Trading Lesson Summary:
While it’s true that options are fixed-time investments that expire on a specific date, this “fixed time” feature doesn’t have to work against you. In fact, it can give you the flexibility you need to focus your trade the way you want – an option you aren’t given with a straight long or short equity position. But there are four things you need to understand in order to secure the biggest profits:
- How expiration dates work
- How time value affects the premium
- When to choose a longer time frame
- When to choose a shorter time frame
Enjoy your long, Memorial Day weekend!