Options Trading: Selecting the Expiration Date II

Part I
set the background. 
Now it's time to consider which factors are
important to the trader, and t
his time I'll answer the question: When
establishing a positive theta, negative gamma spread (a position that
falls under the category of 'selling premium')
is there a good
method for choosing the best time frame – number of days before the options expire?

The short answer is 'no.'  Once again, this commentary is based on my point of view.  There are many reasonable ways to make this decision that I don' see how anyone can claim to know how to choose the best method.  Your goal is to trade positions that fit within your comfort zone and which are profitable.

Let's
limit this discussion to choosing among one-, two-, or three-month
spreads. If you discover that none of these choices works for you, an obvious compromise is to write options on a date, other than expiration day.  There's nothing wrong with preferring 6-7 or 10-11 weeks.  There is a great deal of
flexibility when trading options.

I don't believe there is a 'best' time to write options because there are advantages and disadvantages for different time periods.  My
suggestion is to find a trading methodology that allows you to: not fret over risk, sleep
at night, and especially, like the position.  Too many traders, adopting
the opinions of others, and open positions without really understanding why those trades were chosen.  That may be profitable for a while, but it's not going to help you learn to think for yourself.

Because
premium sellers want to earn profits as time passes, and because
long-term options (LEAPS) have much slower time decay, I'm only going
to consider trading options that expire in four months, or less.

To be consistent when counting the number of days remaining before options
expire, I'll discuss opening new positions
on an expiration Friday.  If you prefer to wait until the following Monday, then
subtract 3 days from the stated time remaining.


Selling the front month.  Expiration: 28 or 35 days.

Most premium sellers prefer collecting the time decay as quickly as possible.  And that leads them to sell front-month options and option spreads.  Some prefer one-week options.  There is also a significant number of traders who prefer to get started a bit earlier and chose 42 to 49 days.

There is no arguing with the fact that near-term options decay more rapidly than others.  And that's very attractive to the premium seller.

The argument can be made that when there is less time remaining, there's a reduced chance for something to go awry.  But to offset that factor, you collect less premium when selling the options, compared with the premium available when selling longer-term options. 

Because time decay is not linear and accelerates as expiration approaches, a 56 day option has far less than twice the time premium of a 28-day option.  That means the near-term option has more rapid time decay.  When the trade works to perfection and the options expire worthless, the maximum possible profit (annualized) occurs when trading these near-term options.  To rephrase, the total premium collected over one year, is greater when selling 28 (or 35) day positions twelve times than when selling  56 (or 63) day positions six times.  And that's good – when nothing bad happens.

The problem is that these short-term options have higher gamma.  In simple terms, that means if the market moves significantly against you, the losses are larger when you are short front-month options.

To see for yourselves that this is true, look at an ITM spread.  Today, RUT is near 560.  If you compare the values of the 540/550 spread, you will see that this spread is priced higher for AUG than SEP, which in turn, is higher than Oct.  Thus, when the market goes the wrong way, you can lose more money more quickly.

The reason the near-term, ITM spread is priced higher is because there is LESS TIME for the spread to move OTM. Thus, it's more likely to be worth $10 when expiration arrives.

Sure, you can adjust the position and prevent holding positions that are so deep ITM, but the point is to show that near-term options come with special risk – to compensate for the special rewards that come with rapid time decay.

Selling two-month options and spreads

Selling spreads 8 or 9 weeks before they expire represents a good compromise – if the negative features of writing front-month options concerns you.  Time decay is less rapid, but the options have less negative gamma.

You remain in jeopardy of seeing a large move in the price of the underlying asset, but there is the offsetting compensation of collecting a higher cash premium for the trade.  More cash is beneficial in two ways.  First, the potential profit is higher (obviously).  But, more cash also means that the maximum loss is reduced.  Thus, you have more potential reward and less potential risk.  Remember that the reward is less on an annualized basis – when all goes well – than when using front-month options.  But in the real world, all does not go well (at least not month after month after month), and less risk and more reward is attractive to the less aggressive trader.


Selling three (or four) month options and spreads.

The opportunity to sell four-month options is not always available, but when you trade broad based indexes such as SPX, NDX, or RUT, that opportunity is available a few times each year.

Choosing 13 week spreads provides more of the same.  Less immediate risk (because gamma is reduced); less immediate reward (because theta is reduced), more time for something bad to happen (but higher premium and a better risk/reward ratio).

There is no way to say that these options are 'better' to write than shorter-term options, but it depends on your style of trading.  I recommend these options for the more conservative investor because 13-week options can be repurchased after 9 or 10 weeks have passed.  You do not earn the maximum, and you would forgo the most rapid time decay, but you would also gain the advantage of not owning the position when it becomes most risky – as expiration nears and gamma increases.

Prime consideration:  For me, the number one factor that tells me whether to write three (or four) month options is the level of implied volatility, as measured by VIX, the CBOE volatility index. Selling naked options or selling call and/or put spreads result in negative vega.  I don't enjoy being short vega under two conditions:  a) I anticipate that vega will move higher soon, or b) VIX is at a relatively low level and I don't want to be selling volatility (vega) at that level.  Obviously we don't know in which direction IV will be moving next, but if you don't want to take vega risk, then avoid selling spreads with this much time remaining.

Bottom Line If you are a premium seller, there are decisions to be made each time you open a new position.  And those decisions are based on risk – and that means the Greeks (which are used to measure risk) should be considered. Theta, gamma, and vega are all in play when selling option premium, and assuming you establish a position with a delta that suits your market bias (bearish, bullish, or neutral), then you must decide how badly you want that rapid time decay, or how conservative you want to play by accepting positions with less risk.

I prefer 13-week iron condor trades.  But, with IV at reasonable – but not high – levels, I've been buying 8-9 week iron condors lately.  I'm sure that will change some day. 

If you find a strategy that is comfortable to trade and is making money for you, congratulations.  That's the goal.

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