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Selecting options expiration dates : Thêta

Montréal Exchange
January 24, 2017
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Selecting options expiration dates : Thêta

Before selecting an expiration date on an option contract, it is important to review some basic concepts of option trading.

  1. Options are perishable

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Remember that the premium of an option is defined as a tangible value, determined by the relationship between the strike price and the price of the underlying stock (also called the intrinsic value) and by a time value, which is interpreted as a measure of the value of market uncertainty.

The more uncertainty there is concerning the underlying’s future value, the greater the (time) value of the option, and vice versa.

 

  1. Upon expiration, the option’s premium consists solely of its intrinsic value. The time value is nil!

So how can we select an effective expiration date on an option contract?

This will depend on several factors:

  • The magnitude of expected changes in the price of the underlying (timing)
  • The degree of volatility (announcements of financial results, market events, etc.)
  • The probability that market predictions will come true
  • The type of option strategy: a call or a put

 

To help us make this decision, we will now look at a variable that is key to assessing the premium on an option: the Theta coefficient.

Theta is the coefficient of the sensitivity of an option’s premium to the passage of time.

It measures the negative impact of the decaying time factor on the option’s premium.

You can obtain Theta using the option calculator found by clicking here:

http://m-x.ca/marc_options_calc_en.php.

Selecting an expiration date: Basic concepts

  1. Options with short-term expirations

  • Shorter-dated options have a high Theta coefficient; in other words, their time value is decaying very quickly as they approach expiration.
  • Since the time value is decaying more quickly, it is also very likely that they will be worthless on expiration.
  • For these reasons, the premium on such options is lower, although they offer considerable leverage.

Conclusion:

Options with shorter-term expirations may be preferred when there is a marked change in the price of the underlying.

  1. Options with long-term expirations
  • An option with a long-term expiration gives investors more time to see their market forecasts materialize.
  • Its Theta coefficient is low or close to zero; in other words, its premium is unlikely to be affected by the time factor.
  • However, such an advantage comes with a downside: the premium is high, so it costs more to take a long-term option position.

 

Options with long-term expirations can be part of an option writing strategy, to benefit from the high premium, or at a time when the market is consolidating or stable.

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