When is the optimal time to put on an options trade? - Option Posts

When is the optimal time to put on an options trade?

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Options trading is unique in that options contracts expire at a specific point in the future; this time component makes them fundamentally different from other kinds of trading. However, timing can be a tough aspect for new traders to understand. For any one stock’s options, you can choose from many different expirations, ranging from a few days all the way up to a few years. So, which expiration is best?

In short, the optimal expiration to initiate an options trade depends on your strategy—whether you are selling or buying options. In this article, we will explain why we typically choose 45-day expirations when we sell options and 60-75 day expirations when buying.

Selling Options

When selling options, we typically go out to 45 days until expiration. This is when we maximize theta (time decay), while minimizing gamma risk.

When there is high implied volatility, options prices are expensive. This is the type of environment in which we prefer to sell options. As options sellers, positive theta works in our favor, so we want to initiate a trade when theta begins to accelerate, which occurs around 45 days until expiration.

Time decay, or theta, is the amount that an option decays just through the passage of time. At expiration, the option will become worthless if out-of-the-money. However, theta is not linear across time. Options decay in an exponential fashion as you approach expiration.

option time decay graph

As you can see in this graph, the rate of time decay accelerates as the expiration approaches. As options sellers, time decay works in our favor, because it allows us to sell something that is expensive and that will eventually decrease in value so that we can buy it back at a lower price for a profit.

With only this information, you might think that placing trades as close to expiration as possible would be the best move, since the highest rates of decay occur right before expiration. Initiating trades right before expiration would also reduce the time we would have to hold a position, theoretically minimizing our risk.

However, it’s not quite that simple: as expiration approaches, gamma also increases. Gamma is the rate of change in delta for every dollar increase in the stock price; it tells you how fast Delta changes when the underlying stock price changes. Options with higher gamma are riskier, since small moves in the underlying stock will have disproportionate effects on the option price.

Check out our list of 66 options trading terms defined over at this blog post.

option gamma increase

This graph shows that as the time to expiration decreases, gamma increases, all else equal. As expiration approaches, option price fluctuations have greater magnitude in either direction as the stock price goes up or down. Because we believe that stock prices are unpredictable, this increased risk is not one we like to take.

Example:

Scenario 1: Assume the following: Stock price is $50, Delta is .50, Gamma is .10, time to expiration is 6 months. The current option price is 1.50.

If the stock price moves from $50 to $51, then the option price moves from 1.50 to 2.00. If the stock price moves from $51 to $52, then the option price will move from 2.00 to 2.60.

Scenario 2: Assume the following: Stock price is $50, Delta is .50, Gamma is 1.00, time to expiration is 7 days. The current option price is 1.50.

If the stock price moves from $50 to $51, then the option price will move from 1.50 to 2.00. If the stock price then moves from $51 to $52, then the option price will move from 2.00 to 3.50.

Through these examples, you can see how an increased gamma increases the magnitude of the option price fluctuations. This is added risk that you would take when initiating options trades which are closer to expiration.

Therefore, we want to maximize theta, but minimize gamma, and we want to optimize the amount of time we hold an option to maximize the chances that it will go our way. We do this by initiating trades around 45 days to expiration, when the risk-reward profile between gamma and theta is most in our favor.

Earnings Trades

One exception to the 45-day rule is with earnings trades.

Companies release earnings reports every quarter. These are press releases that tell the public how each company did financially in the past quarter. Depending on how well (or poorly) they performed, earnings reports can have significant impact on a company’s stock price. Because of this, the implied volatility of the company’s stock price increases, and option prices will be more expensive immediately prior to the release of earning reports.

However, after the press release goes out to the public, implied volatility collapses. This is because the unknown becomes known: there is no more uncertainty in regard to earnings. This inflation of volatility prior to the earning report release, and its subsequent crash, change the environment in which we can sell options.

During earnings, we trade options closest to expiration (<5 days). This allows us to make an isolated trade based just on the earnings report. In this scenario, options with fewer days until expiration have the greatest implied volatility crash – the decrease in implied volatility after the earnings report is released. A decrease in implied volatility is good for option sellers because it decreases the option price; option sellers want to buy back option contracts for a cheaper price to make a profit.

Buying Options

During low implied volatility environments, option contracts are cheap. This is the type of environment in which we consider strategies that involve buying options (albeit a lower probability proposition). When you buy an option, you are buying a decaying asset that eventually will go to zero. However, whenever you buy something, you eventually hope to sell it at a higher price. Time decay works directly against this goal, so you’d want to minimize theta in this scenario. When buying contracts, you want to close your position at a high price before theta begins to accelerate (at fewer than 30 days to expiration). In option contracts with more than 60 days to expiration, the effect of theta is minimal.

Additionally, since strategies that involve buying options have a statistically lower probability of success, using options with 60 days or more until expiration creates more time to eventually become right on the stock price direction.

Summary

There are many options expirations available to trade, but we typically trade options with 45 days until expiration for our go-to strategy of option selling. This time frame maximizes our time decay while avoiding the negative impact of gamma as expiration approaches. However, if implied volatility is not high, and we resort to strategies that involve buying options, we like to extend our trade timeline and go out to 60-75 days until expiration. Going further out in time minimizes time decay and also gives us time to become right on stock direction.


Thank You For Reading!

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