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Options trading: One piece of advice you would give to newcomers
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doctorpot1 joined discussion · Jun 24, 2023 13:18

My personal rule of thumb for choosing option's expiration date

TLDR: Knowing how time decay works, the rule of thumb that I used for choosing an option's expiration date is: 1. If I'm selling an option, I choose an expiration date that is around 30 days. 2. If I'm a buyer of an option, I choose an expiration date that is more than 1 year.
Story time
If you do not know what an option is, do read the Explained Simply: Options series here
doctorpot1: Explained Simply: Options 101
In the market, there aren't many things that are guaranteed. We can't guarantee that a growing company will have a growing share price. We can't guarantee that company in distress will go bankrupt. Look at how the apes saved $GameStop (GME.US)$ and $AMC Entertainment (AMC.US)$ through the pendamic.
However, there is one thing that we can 100% guarantee, and that is time will move forward. The chart will always move to the right. Which means that we can 100% guarantee that an option will lose its time value over time. If you see the video below, you can see that as time passes, the price of the $Intel (INTC.US)$ option crashes, even though the share price didn't move.
source: https://optionalpha.com/learn/theta
source: https://optionalpha.com/learn/theta
Time value also decay faster and faster over time. With the last 30 days having the worse decay. This means that as a seller of an option, they earn more and more over time. Whereas for the buyer of an option, they lose more and more over time.
Earning from the ever growing decay of time value is the basic principle of the theta gang. There is a whole option subculture that specifically build their entire option strategy on earning from the decay of time value (which is known as theta). I'm also a subscriber of this philosophy.
Thus, having this knowledge of time decay, I have developed a general rule of thumb that I use for choosing an option's expiration date. If I'm selling an option, I choose an expiration date that is around 30 days. However, if I'm a buyer of an option, I choose an expiration date that is more than 1 year. Why?
Reasons for selling options with 30 days till expiration
The simple reason is because time decay grows exponentially starting from the 30 days mark, thus I would earn the most from it this way. If we were to sell an option that expires in 300 days, as compared to selling ten 30 days options one after another. The ten 30 days method would earn way more money than the 300 days method.
Another reason why I would choose the 30 days contract is to be able to adapt to the changing market environment. Especially, when it is a bear market. As you can see for $NIO Inc (NIO.US)$, I had been able to adjust the strike price from $10 to $7.50 over time, as the share price keeps falling over time.
My personal rule of thumb for choosing option's expiration date
However, do note that there is a reinvestment risk for selling short dated option. For example, if the share price of NIO keeps rallying from $7.50 to $75, we won't be able to sell the $7.50 PUT option every 30 days for a good amount of premium.
Reasons for buying options with more than 1 year till expiration
As a buyer of an option, I like to buy long dated contract so that I pay the least amount of time value per day in the earlier stage of the contract. This means that if I decided to close my position early, I won't suffer a huge lost in time value.
On top of that, I have a long enough time for my hypothesis to come true.
My personal rule of thumb for choosing option's expiration date
For example, I had bought this $Grab Holdings (GRAB.US)$ CALL option more than a year back, and it still have half a year left to go. When I purchased this option, I have given GRAB more than 1.5 years to fulfil their promise of breakeven even by 2024. Giving GRAB enough time to make decisions that would be able to rally their share price. Giving myself enough time to survive the bear market, and pray that it will be a bull market soon. There is still 6 months left to see if this -36% would become a +36% or not
However, long dated option doesn't come cheap. This is because, we have to pay the time value up front like a pre-paid card. Even though we will be paying a tiny amount of time value per day in the beginning, but we need to "pre-pay" for all the time value first.
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doctorpot1
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crawled out of poverty, working towards FIRE!! (financial independence, retired early)
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