Lessons from the Pros


Options – Which one is the Right One Part 3

In Part 1 of this discussion, I talked about the various types of options expiration dates that are available (monthly, quarterly, weekly and LEAPS). In Part 2, I explained why for most underlying assets, the monthly options are often a better choice than weeklies or quarterlies: because of better bid/ask spreads.

The final factor to consider in selecting an expiration date is the amount of time that we plan to be in the trade.

Free Trading WorkshopEvery trade with options, or anything, else is based on an opinion on the future direction of the price of what is being traded. When we buy a stock as an investment, we might do so in the general belief that its price will rise over time. We may not concern ourselves with just when it is going to move and how far. Shares of stock never expire and we can hold them as long as we want.

If we buy a stock as a trade (rather than as an investment), by definition we intend to close out the trade at a profit based on some pre-determined plan. If there is no pre-determined plan other than the vague hope of a profit, then the purchase is not really a trade, it is just a risk.

Our plan for a trade must include some signal to tell us when it is time to close it out. This implies that we need a target price. If I buy this stock and its price goes up, how much is enough? At what price should I sell? This must be decided before we enter the trade. Incidentally, we also need to decide at what price we will terminate the trade if it goes against us. If I buy this stock and its price goes down, how much is too much?

Exactly how we pick our entry prices, target prices and stop-loss prices is beyond the scope of this article, and is the entire subject of our Professional Trader class. You can assume here that these have been selected based on sound analysis.

If this is an option trade, we must make sure that the option(s) we select have an appropriate lifespan. If we are buying options, of course, we need to make sure that they are going to exist long enough for the stock to make its move, and there is a little more to it than that.

Since we have been looking at the stock of General Electric up to now, let’s look at its recent chart:

Determining the target price for your trades is essential

Let’s say (and this is not a recommendation, just an illustration) that we think the current price level around $28 is where GE will make its stand and reverse the recent selloff; and that we think GE could rally back up to the area of its recent highs around $31.

If we plan to take advantage of this move by buying options, we need those to remain in existence long enough for the move to complete. One way of estimating how long that might be is to look at previous instances where that same trip was made. Looking at the chart above, we can see that the last time this occurred, the rally started on October 15 and ended on November 12, 28 days later. This is considerably longer than it took for the price to make the return trip, which was just about ten days. This is not unusual. In general, stock prices fall faster than they rise. We say that prices tend to crawl up the stairs and then jump out the window.

So, if we planned to buy call options in this case, we would certainly want options that would remain in existence for more than a month. When buying options we not only need not a target price, but a target date. Picking options with too short a life won’t work as we will run out of time before the move completes.

Then why not just pick options with a very distant expiration date, say a year? The reason not to do that is that we have to pay more for an option the farther out its expiration date is. Calls at the $28 strike that expire in February cost about one dollar. Those that expire next January cost about three dollars. The best balance when buying options is to select an expiration date that is about two months further out than your target date. Not only will you have plenty of time for the expected move to happen, but you will also not own the option in the last days of its life. This is important because the value of options decline over time, at an accelerating rate. By planning to sell them before they reach the last couple of months of their lives, we avoid holding in that period.

Finally, we should consider the question of whether in this circumstance we would want to be buying call options at all. We could also make money from this move by selling put options short instead. That is a choice that we would make based on whether options were underpriced or overpriced, which is a subject for another day. If our choice does turn out to be to sell puts, then a different set of timing factors come into play. We’ll look into those in a future column.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.