Front Month or Back Month Options?
Posted by Pete Stolcers on August 2, 2008
Option Trading Question
Today Dan W. asks, "Your last couple of recommendations have been for near month put options with very little time left. Why not use an option with 30 or 60 days to buy more time for a move? I read that you should never hold a an option with less than 30 days remaining because of declining time value, theta."
Option Trading Answer
Great question. Once you’ve done your research and identified a stock, you have to dissect your opinion and identify the magnitude and duration of the move. If I am looking for an immediate jump, I might opt for a front month out-of-the money option with a few days left.
Let me take a step back and state that if you are looking for a long term move to unfold and your time horizon is 4-5 months, absolutely you should “buy time”. In that case, you don’t want to be subjected to time premium decay. Unfortunately, most people read about this pricing principle and they universally trade the back months. This approach is flawed for a few reasons.
1. The trader is immediately hedging their opinion. If the trade does the unexpected they rationalize, “I still have time”. They over-stay their welcome and they don’t don’t take the loses when they should have. You need to commit to a specific time frame and state why you think that period is appropriate.
2. Back month options are fat with time premium and the deltas are much lower. You can get the move and not make much (if any) money.
3. The options are much less liquid. They have wider bid/ask spreads and your slippage will increase.
For the most part, the longer my time horizon, the more hedged my opinion and the less certain I am of the outcome. These trades are fairly limited because I can normally find better opportunities where I have a stronger opinion.
Let’s take a look at a few examples.
Last April I looked at PCAR. The company has been very profitable and the heavy machinery group had been strong. The stock had been trading between $70 and $80 for the prior year and the premiums were “rich”. The stock was at multiple horizontal support ($70) and I decided to buy the August 65 calls. I went with an in-the-money back month option because I felt the move would materialize but I was not certain of the time frame. I went in-the-money because I wanted higher deltas and I did not want to buy implied volatility. I rationalized that if the stock pulled below $70 these options would hold up well and I would be able to get out. If the stock went up I would be able to sell some front month nearer term options against the position (diagonal spread) and take advantage of time premium decay. The trade has worked well.
Here’s another example. In June, three days before expiration I saw and opportunity. The energy and basic materials stocks had been smashed in a matter of days. ACI a coal producer was trading at $38 and the June 40 calls were offered at $.25. the stock had fallen from $52 and I was looking for a very sharp short covering rally to unfold immediately. I knew the oil inventory numbers were going to be released the next day and that they might spark that rally. This was not going to be a one month trade. The move happened and those options got as high as $1.60 in 2 days. In this case, there is not a more efficient trade. Those options went up more than 500% and my risk was $.25. Were they subject to accelerated time premium decay? Yes. Were they “expensive”? Yes. Does that mean this trade should have been avoided? No.
Last week I placed a trade on RIMM. The stock had been in a down trend for months and it had challenged the one year low ($60) before earnings. They announced “in-line” performance and the stock gapped up. A few days later, the FOMC meeting created a huge market rally and the stock jumped up to $71. Even though the market continued to show signs of strength, the stock was unable to add to its gains. The bounce was failing and the stock looked ready to “fall”. I felt that it would fill the gap and perhaps test the lows again. I also felt that the market had run up on short covering and that the release of the Unemployment Report would lead to a sell off Friday. Thursday afternoon we bought the July 70 puts that would expire in two weeks. The stock was at $69.20 and we paid $2.20. The market declined as expected and the stock actually went up. When it was apparent that the stock was not going to “behave” according to my expectations, I got out Friday and took a $.50 loss. I was right on the market but I picked the wrong horse. I stayed true to the plan and I took my lumps. There was no need to buy August options, I was not going to be in the trade that long. As it turns out, the trade would have worked out well. (It still may be worthwhile - take a look.)
Let your opinion drive you option strategy! If you trade front month, you have to be VERY accurate and the move has to happen right away or you’re out. These trades will add volatility to your performance. You will have big winners and losers. If your analysis is good, these options can be an efficient choice. Most of my trades are short-term, so I do trade a lot of front and second month options. I also like to sell front month premium.