When I first started trading options professionally, there was a rule at our firm about which options we could trade in our books. In terms of time to expiration, you could trade options with a term that was the square root of the number of years of experience you had.
Even new traders could take positions in short term options, but longer terms were only for the experienced.
For instance you had to have been trading for four years before you could trade options that had two years remaining until expiration.
There were two main reasons for the rule. First, short-term options are more liquid – usually by a wide margin. If you find yourself in a jam in short-dated options, you can generally trade out of it easily. There was no guarantee that you won’t lose money, but it probably isn’t going to be uncontrollable.
The other reason is because of the “Greek” sensitivities and the way they change over the life of an option.
The important greeks for this example are Gamma and Vega.
Gamma is the sensitivity of an option’s delta to a change in the price of the underlying. Gamma increases as expiration approaches.
In an extreme example, picture an option that is only a few minutes away from expiration. In-the-money options will have 100 delta or something very close, while out-of-the-money options will have a delta near zero.
With so little time remaining, if the price of the underlying moves through a new strike, making a previously ITM option OTM and vice versa, the deltas of those options would flip. The previously 100 delta option would be zero and the previous zero would have 100 delta - the biggest possible change in delta.
Extremely short term options also have very little vega. Because they have so little time value remaining, even a large change in implied volatility won’t have much of an effect on their price.
It’s exactly the opposite at the long end of the options term structure.
An option with two years until expiration – generally the longest term exchange-listed contracts – has almost no gamma. Picture that the farther out you go in time, the wider the expected possible range for the underlying. That means all options’ deltas will be closer to 50 – because all options near at-the-money are equally likely to wind up in-the-money.
Current moves in the underlying don’t have much effect (in percentage terms) on the delta of the options.
But those long options have a lot of vega. With two years left to expiration, even a small change in implied volatility has a big effect on the premium of the option.
What does this mean for the average investor or trader?
Long-dated options probably don’t suit your needs very well. If you’re using options as a way to speculate on the direction of a stock (or other underlying security), shorter-dated options represent a better way to be rewarded if you’re correct while reducing other factors that are largely beyond your control – like changes in implied volatility.
In general, 30-90 days is the “sweet spot” for most options trading strategies. If you’re correct and the price of the underlying goes exactly where you expected, you’re rewarded with quick profits. If the position doesn’t work, you don't have to wait until expiration. The options are liquid enough for you to pull the ripcord and cut your losses whenever you choose.
If you have the sense that a given security will rise, but you’re not sure when it will happen, it can be tempting to buy those long-dated calls, but it’s probably not the right decision. The value of your position will end up being much more dependent on the direction of implied volatility than on the direction of the stock. You’ll also be shelling out a large premium, reducing the leverage you get by buying options and comitting trading capital that could be used elsewhere.
Of course, that could work in your favor as well as against you, but unless you have time to watch the trading activity in those options all day, every day to formulate an opinion of supply and demand, the effect of moves in implied volatility will be fairly random to you – a wildcard factor.
For almost all traders, those 30-90 days options offer the most bang for your buck – and the greatest chance of closing out your trades with a profit.
One final note: The "mailbag" type Know Your Options columns continue to be the most popular, so if yoou have a question about this or any other options-related topic, please don'y hesisitate to send me an email at dborun@zacks.com and ask.
-Dave
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.
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What's the Correct Time Period for Your Options Trades
When I first started trading options professionally, there was a rule at our firm about which options we could trade in our books. In terms of time to expiration, you could trade options with a term that was the square root of the number of years of experience you had.
Even new traders could take positions in short term options, but longer terms were only for the experienced.
For instance you had to have been trading for four years before you could trade options that had two years remaining until expiration.
There were two main reasons for the rule. First, short-term options are more liquid – usually by a wide margin. If you find yourself in a jam in short-dated options, you can generally trade out of it easily. There was no guarantee that you won’t lose money, but it probably isn’t going to be uncontrollable.
The other reason is because of the “Greek” sensitivities and the way they change over the life of an option.
The important greeks for this example are Gamma and Vega.
Gamma is the sensitivity of an option’s delta to a change in the price of the underlying. Gamma increases as expiration approaches.
In an extreme example, picture an option that is only a few minutes away from expiration. In-the-money options will have 100 delta or something very close, while out-of-the-money options will have a delta near zero.
With so little time remaining, if the price of the underlying moves through a new strike, making a previously ITM option OTM and vice versa, the deltas of those options would flip. The previously 100 delta option would be zero and the previous zero would have 100 delta - the biggest possible change in delta.
Extremely short term options also have very little vega. Because they have so little time value remaining, even a large change in implied volatility won’t have much of an effect on their price.
It’s exactly the opposite at the long end of the options term structure.
An option with two years until expiration – generally the longest term exchange-listed contracts – has almost no gamma. Picture that the farther out you go in time, the wider the expected possible range for the underlying. That means all options’ deltas will be closer to 50 – because all options near at-the-money are equally likely to wind up in-the-money.
Current moves in the underlying don’t have much effect (in percentage terms) on the delta of the options.
But those long options have a lot of vega. With two years left to expiration, even a small change in implied volatility has a big effect on the premium of the option.
What does this mean for the average investor or trader?
Long-dated options probably don’t suit your needs very well. If you’re using options as a way to speculate on the direction of a stock (or other underlying security), shorter-dated options represent a better way to be rewarded if you’re correct while reducing other factors that are largely beyond your control – like changes in implied volatility.
In general, 30-90 days is the “sweet spot” for most options trading strategies. If you’re correct and the price of the underlying goes exactly where you expected, you’re rewarded with quick profits. If the position doesn’t work, you don't have to wait until expiration. The options are liquid enough for you to pull the ripcord and cut your losses whenever you choose.
If you have the sense that a given security will rise, but you’re not sure when it will happen, it can be tempting to buy those long-dated calls, but it’s probably not the right decision. The value of your position will end up being much more dependent on the direction of implied volatility than on the direction of the stock. You’ll also be shelling out a large premium, reducing the leverage you get by buying options and comitting trading capital that could be used elsewhere.
Of course, that could work in your favor as well as against you, but unless you have time to watch the trading activity in those options all day, every day to formulate an opinion of supply and demand, the effect of moves in implied volatility will be fairly random to you – a wildcard factor.
For almost all traders, those 30-90 days options offer the most bang for your buck – and the greatest chance of closing out your trades with a profit.
One final note: The "mailbag" type Know Your Options columns continue to be the most popular, so if yoou have a question about this or any other options-related topic, please don'y hesisitate to send me an email at dborun@zacks.com and ask.
-Dave
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.