Trading Options Near Expiration

The great dilemma for options traders is well known: Options close to expiration cost less but expire soon. Options with more time to develop profitably cost more. How do you balance these conflicting attributes?

Trading options very close to expiration and containing little or no time value might be the most powerful form of leverage you can use. Even though expiration happens soon, there are some situations in which short-term options just make these. Three cases are the most advantageous:

1. Long calls or puts in a swing trading strategy.

The long option strategy is a higher risk than many traders realize. Three out of every options expires worthless, so you have to be an expert at timing to improve on those odds. If you are a swing trader and you rely on reverse signals (narrow-range days, volume spikes, or reversal days), or if you rely on candlestick formations also indicating a strong chance for a turnaround, you probably expect to have positions open for only three to five days.

In the swing trading strategy, long options reduce the risks of shorting stock and even going long. You can use long puts at the top of the swing and long calls at the bottom, drastically reducing your market risk. Options expiring in less than one month provide the best leverage, because time decay is no longer a factor.

For example, if you are swing trading on Yum Brands YUM you have noticed a decline over a period of days. By May 3 close, the stock had fallen to $72 per share. If you believe it is like to bounce back, you could swing trade by buying a May 72.50 call for 0.95. As a swing trader, you rely on a three-to five-day swing cycle, so even though this open expires in two weeks, you do not need a lot of movement. If the stock were to rise to $74 by expiration, you will make a profit. The same rationale is applied at the top of a swing using short-term long puts.

2.Short positions for higher annualized return.

When you write covered calls, longer-expiring contracts yield more cash, but on an annualized basis, your yield is always higher writing shorter-expiring short contracts. (To annualize, divide the premium by the strike; then divide the percentage by the holding period; finally, multiply by 12 to get the annualized yield.)    Picking shorter-term short calls works just as well for ratio writes and collars.

For example Johnson Controls JCI closed May 3, 2012 at $32.54. A covered call for the May expiration could be written based on strike selection. The May 33 call was at 0.35, and the May 32 call was at 1.13. The choice relies on whether you believe the stock will remain near its current price for two weeks, will rise, or will fall.

Given the chance of exercise, there is an equal chance of rapid premium decline due to time decay, so that the 32 call could be closed even with the underlying at or slightly in the money. At the closing price on May 3 there was 0.59 of time value remaining, and this will evaporate rapidly over the coming two weeks.

3. Spreads, straddles and synthetics at times of exceptionally high volatility.

Any time you open up spreads, straddles or synthetic stock positions, you are likely to include open short option positions. Given the more rapid time decay toward the end of the option’s life, you get higher annualized return when you use shorter expirations, especially if you also spot a spike in volatility. This tends to be very short-lived, so going short when premium are rich often produces fast profits in changes in option premium.

Time decay happens very quickly during the last two months before expiration, so focus on short positions within this range. Remember, just as time decay is a big problem for long option positions, it is a great advantage when you are short.

Such combined positions are available in a wide variety. For example Walt Disney DIS closed on May 3, 2012 at $43.81. A synthetic short stock position could be opened with a short May 43 call at 1.53 and long May 43 put costing 0.73. The net credit is 0.80, a nice cushion in this strategy and given the approaching expiration.

Or in the same circumstances, you could create a collar with a 44 short call (0.93) and a 43 long put (0.73) a net credit of 0.20 before trading costs.

It is not realistic to assume that any duration or position type is “always” positive or negative. It all depends on the strategy, the premium level, and your expectations about how the stock price is going to move within the trend, or correct after it changes in one direction too quickly.

These option strategies rely on timing, notably for short sides of combinations. Implied volatility rises and falls and you will get maximum premium for the short positions when IV is exceptionally high. So in addition to identifying risk-management strategies for stock in your portfolio, you also will benefit from tracking IV on the stocks you own, as part of your options strategy.

A volatility-based strategy can be complex without help, but it can be simple and easy with the right tracking tools. To improve your option trade timing, check the Benzinga service Options & Volatility Edge which is designed to help you improve selection of options as well as timing of your trades.