If you're just getting started with trading options, you may run into a financial adviser or broker telling you stay away from them.
You'll hear that options are "too risky!" (which we've already proven is untrue) or "too complicated!" (also untrue)...
Or this...
"Options are fixed-time investments that expire on a specific date!"
That is true. But that "fixed-time" feature doesn't have to work against you. Quite the opposite. It gives you the flexibility to focus your trade the way you want to - a flexibility you don't have with a straight long or short equity position. But you need to know how to use it.
If there's one thing you need to know about options, it's how to handle this "fixed-time" aspect of trading them. Picking the right expiration date can make the difference between a small 15% gain and a huge 300% winner.
So today, I want to spend some time helping you get this all down pat, so all your broker reps will need to do is provide you the most efficient means of executing your orders. (Heck, if you're using an online platform, you may never have to talk to them at all.)
And then look out for my email next week, when I'll show you how to focus your trade by picking the right expiration, as well as my personal favorite timeframe for trades.
Let's jump right in.
Note from Tom: I am primarily going to discuss dealing with time on straight options trades, meaning buying call or put options. I will, however, follow up with an observation about the loophole trade and a benefit of this type trade over a straight option trade.
How Expiration Dates Work When Trading Options
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 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.
On optionable stocks there will always be expirations for the current month and the next month out. For example, here we are in August. There will be August AND September expirations. Then options fall into whatever option cycle they are a part of.
The standard expiration for each month is considered the third Friday of each month. There are weekly options on some of the more liquid stocks.
Reminder: The current month plus 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.
How Time Value Works to Inform Pricing
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. 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 to Choose a Longer Timeframe
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 about it like this: You are taking on more risk by having a shorter timeframe 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:
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:
But here's the trade-off...
When to Choose a Shorter Timeframe
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.
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About the Author
Tom Gentile, options trading specialist for Money Map Press, is widely known as America's No. 1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Tom has taught over 300,000 traders his option trading secrets in a variety of settings, including seminars and workshops. He's also a bestselling author of eight books and training courses.