The Value of Time
“It’s all about timing,” or “timing is everything” are both expressions I’ve heard since I was little. Time is one of the most precious of all things, and make no mistake… it is always ticking. As we get older, the value of time will increase significantly to each of us. Near the end, many would be completely content with giving everything they’ve ever earned for just a little bit more time.
As an options trader, time is crucial. Too much of it, and you’ll walk away with peanuts for your efforts. Too little, and you can watch your entire trading plan carry out in front of you, only to have it ripped away right before your eyes and watch your position expire worthless for the sake of… time.
Buying an option contract and buying shares of stock are different in several ways, with one of the biggest differences being time. When you buy (or sell) stock, time decay (in most cases) has no influence or effect on your position. When you buy (or sell) an option contract, as part of the contract you also agree to an expiration date. For the majority of optionable stocks, there are typically weekly, monthly, and quarterly cycles. In short, common stock shares (or commons) don’t expire, while options contracts do. This time decay, also classified by the options Greek “Theta,” is displayed on the graphic below:
Choosing Options Expiration Dates
When choosing an expiration date, your style of trading should be your guide. This is to say that if you’re primarily a day trader, you will likely want to trade the nearest expiration cycle. A swing trader may want more time in the trade, and find expiration cycles of 25-50 days to be more appropriate to their style. Some may trade numerous methods based on what the charts tell them. Generally, more time costs more money to reserve. The weeklys may be going for $.20 while the monthlys are over $1.00 and quarterlys more than $3.00. Options contracts are decaying assets, meaning the longer you hold the more the value will decay. Since a longer hold costs more to trade, you want the shortest amount of time for your trading plan to complete as to leave as little on the table as possible. This is much easier said than done.
If buying an option based on a technical pattern of the underlying stock chart, note that certain chart patterns complete quicker than others. Rising wedges, falling wedges and coil patterns for example, tend to yield sudden movements in the stock after support/resistance is broken. In such patterns, shorter expirations may be more appropriate (and profitable).
It really boils down to your overall risk tolerance as a trader. What are you comfortable risking? Some traders can risk more than others more comfortably. Others insist on protecting capital at all costs.
Related Reading: Risk Management
High Risk, High Reward
If your style is one of higher risk, a shorter term expiration is likely your way of play. Short term expirations can yield much higher gains than longer term expirations if the underlying stock moves in your favor. These are great for patterns spotted on lower time frame intraday charts like the 1, 5, 15, and sometimes the 30 min. However, if it goes against you this same leverage can hit you on the red side just as quickly. This method is buying the least amount of time for the move you are after, maximizing your leverage, but increasing your time decay rate.
If you’ve been witness to gains of 1000% or more, they likely came from out of the money (OTM) weekly contracts… and very well may have been “lotto” plays on expiration Fridays. “Lotto” plays refer to trades that are legitimate gambles and are generally have lower success rates. All-or-nothing plays. Huge win or a flop. These short dated OTM options are gamma sensitive, meaning they will move more for every movement in the price of the underlying stock. To put it simply “it will generate a big return quickly if I nail a quick move in price action.” Commonly, gamma sensitivity is at it’s highest point on expiration Fridays.
Often, experienced options traders will day trade weekly options contracts in order to build “free positions.” Essentially, these positions aren’t free, but are comprised of 100% profits rather than being paid for with direct capital. “Freebies” are much easier to let ride in lotto-style scenarios, and are in some cases considered “risk-free.”
A well-known strategy using this technique is to day trade your way into an earnings announcement. Day trade weeklys for any charts or names you want. With the profit from those trades, roll them into a “free position” prior to an earnings report. Do this very near (or on) expiration Friday, and gamma sensitivity is compounded. As shown on the time decay graphic above, the total percentage of premium remaining on or near expiration is at it’s lowest point, meaning the cost of the OTM options contract will be dirt cheap (as the odds of it ending ITM is significantly lower at this point). If it goes your way (Friday ramp/pull), it could be an enormous gain. While the upside potential is huge when buying these contracts, your risk is always limited to your total investment. In other words, you could risk a $500 loss (total investment), but in best case scenarios see potential gains of $5000+ (1000%+). In extreme (and rare) cases, gains of 10,000% or more are possible… which would return $50,000 on your meager $500 “lotto” play… that in the end, costs you 0% of your capital.
Lower Risk, Better Safe Than Sorry
If your style is one of lower risk, a longer term expiration would likely be a more comfortable consideration. Longer term expirations don’t see gains near as quickly (nor as high) as shorter term expirations, but go much less into the red should the underlying move against you. As mentioned before, swing traders may see expirations of 25-50 days out more appropriate based on higher time frame intraday and daily charts.
When trading options, the “safer” trades involve more time than is needed, and are generally a purchase of a strike that is already in the money (ITM) or at the money (ATM). These trades will still see gains should price move in your intended direction, just not at the rate of the higher risk scenarios as mentioned before. The reason being that the downside is significantly lower if it moves against you (and has a better chance of expiring with value) than that of an OTM trade.
You may get into situations where your timing was right, but your strike was off. If your strike is too far out of the money (OTM) near expiration, it may be difficult for you to close your position… and you could potentially end up holding into expiration OTM, leaving your trade completely worthless and resulting in a total loss.
It may help to layout potential scenarios for price using realistic expectations to help choose expiration dates. As you can see from the layout I’ve created below, this example is $KMI shown on the 3o minute chart. The total time since the most recent high has been 11 days. If we establish the POC (located at approximately 22.11) as our target, in the worst case scenario (based on this model), we have projected that it hits the target within 3 weeks at the latest. Therefore, when buying your contacts there shouldn’t need to buy an expiration date any further our than 3 weeks (maybe 4 if you’re the “safe” trader). If you do, you’re essentially wasting your money, as you will pay more for the same strike at a later expiration.
Scenario 1 is a quick spike to POC, a near “V” bottom reversal. A sharp move with heavy buying activity. Scenario 2 is a steady grind to the 21 level, with a slight decline before popping and consolidating just below the target, only to fall back to retest the breakout level before eventually making it’s way back toward your target. Scenario 3 is a slower series of consolidations “stair-stepping” it’s way to the target.
The highest risk trade in this graphic would be the 22 calls that expire after the 1st week. If we take those 22 calls, only 1 of the possible scenarios makes us a winner… but it could be a huge win. The lowest risk would be the extreme opposite, buying the 20 calls that are already ITM that don’t expire until after the 3rd week. While the premium is notably higher, as are your chances of the trade ending in a win… just at a lower gain that the higher risk, further OTM trades. Both the 20 calls (in the money) and 20.5 calls (at the money) for either of the 3 expirations would both be highly probable wins based on these projections. The 21s would be a mid risk, mid reward potential, with the 21.5s and 22s being your highest risk possibilities… all of which are subject to time decay. Taking the 22 calls and having price hit your target within 1 day would be the best case scenario, and would likely yield the highest possible return.
Looking at this same example, I would likely make the decision (based on my trading style) to take the 20.5 calls that expire after one week. They are just OTM, meaning the premium is still low (premiums see greater increase once ITM). As for the timing, gamma sensitivity is higher with the 1 week calls, meaning as long as we see ITM, we should be seeing some nice gains in a short amount of time. In each of the 3 scenarios, the weekly 20.5s (for either of the 3 expirations) look to be a winning short-term OTM options trade.
Trading options can be tricky. There are countless options strategies and methods used today, each utilizing time as a key factor. While other pricing factors (like delta, gamma, and implied volatility) are certainly important, a look at Theta (or time decay) is a great place to begin when starting to understand how options are priced.