Best Durations When Buying and Selling Options (Part 1 of 3)

Are gas guzzling vehicles good or bad?

If you drive one, you're going to hate all those trips to the gas station.

Of course, if you own the gas station, your perspective is likely going to be very different.

When it comes to option trading - where time value is basically the fuel for options - the dynamics are very similar.

Your views on theta - or the daily rate of an option's time decay - will depend on whether you're a net buyer of options or a net seller.

Are you the one buying the gas? Or are you the one selling the gas?

Customizing Your Own Option Strategy - What You Need to Know About Theta

I regularly have personal correspondence with, and provide feedback to, individuals who are working on developing their own customized options-based trading approaches.

And sometimes there can be a common theme as it pertains to selecting a duration, or expiration cycle, for what they're trying to achieve.

So I thought it might make sense to address a key concept in option pricing and durations and explore how that impacts you differently depending on whether you're plan to be a net buyer of options or a net seller of options.

Sell Lots of Time Value, Buy Little, Right?

It's simple, isn't it?

If you're a net buyer of options, shouldn't you buy the options with the least amount of time value?

And if you're a net seller of options, shouldn't you sell the options with the most amount of time value?

While that may sound right on the surface, in reality nothing could be further from the truth.

It's Not the Time Value - It's the Rate of Decay

So let's break this down a little . . .

In option trading parlance, theta is the "greek" in an option's pricing that measures the rate of daily time decay for that option.

Now this is the key - theta is never a constant rate.

• The farther away an option is from expiration, the lower the rate of daily time decay.
• Conversely, the closer to expiration that option gets, the more daily time decay accelerates.

And this is absolutely crucial to understand - theta does not gradually accelerate.

It's more of a parabolic process where the nearer you get to expiration, the more the acceleration of the daily time decay rate itself accelerates.

So What?

If you're going to buy options - calls or puts - or set up net debit spreads, then by definition you're "long" time value.

In other words, you're buying time.

And time (or specifically time value in this instance) is a wasting asset.

The trick then is to choose options that have the lowest rate of time decay attached to them.

And how do you do that?

You buy options with longer durations.

If you buy options with a short duration, it's like driving a gas-guzzling vehicle.

You may not spend a ton at the pump on any given day, but it's a terribly inefficient process, and you're always going to be needing to buy more.

The process is reversed when selling options

When it comes to selling options (or being a net seller of options via credit spreads), the dynamics run in the opposite direction.

Selling options means you're the gas station owner.

Your best customers are going to be the drivers with the worst gas mileage.

When it comes to option trading, that means selling options with shorter durations where the rate of daily time decay is already high - and accelerating.

Buying LEAPS vs. Selling LEAPS

It can be tempting to sell LEAPS (longer term options that don't expire for 1-2+ years) because you get a huge chunk of premium right upfront.

And maybe there's a psychological pay off in that you feel you don't have to stress or worry about a position that far out.

But it's a horrible deal in terms of your own compensation.

It's like selling a year's worth of gas to a driver getting 150/mpg.

Sure, you may sell a fair bit of gas that day, but then your business completely dries up with that customer - and what you've actually done is give that driver a hell of a bulk discount on your product.

Example

Let's look at a real world example from early March of 2018 on INTC . . .

This isn't going to be precise down to the penny - it's just designed to show you the principle in action:

>> INTC was trading around $48/share.

>> The JAN 2020 $47 PUTS (687 days away) on INTC were going for somewhere around $6.50/contract.

>> So you could sell a 687 day put at the $47 strike price (insuring or offering to buy 100 shares of INTC at $47/share) and collect roughly $650 in upfront premium.

That's all time value, by the way, since the strike price was at a level below the current share price.

And when you pro-rate that $6.50/contract in premium over the life of the option, you're looking at roughly $0.95/day in gains from that time decay.

But remember, theta is not a constant pro-rated amount

Theta that far out is very low and only gradually builds over time.

The theta on the JAN 2020 $47 PUT was showing 0.005 - which basically means, all else being equal, in the early period of the trade, you would be accruing about $0.50/day in gains.

As in 2 shiny quarters.

Put On Your Seat Belt!

Compare that to the $47 put that was set to expire in two weeks with a value of about $0.86/contract and a theta of 0.04 - here you're accruing $4.00/day in gains.

So the two week short put is allowing you to accrue gains at a rate that's 8 times greater than that of the 22 month short put.

And that rate is accelerating.

So again - the principle is pretty clear . . .

>> When you're a net buyer of options, you're better off buying longer durations with much slower time decay rates.

>> And when you're a net seller of options, you're better off selling shorter durations with much higher time decay rates.

Next - Part 2: The Sweet Spot Expiration Date When Selling Options

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