Why do you buy options that are several months out as opposed to the next expiration month?

  Many newsletters advocate buying current expiration or the next month expiration options. While cheaper, we have found that unless you are very, very careful, these options can prove to be costlier.

Options are a wasting asset. They can decrease in value through a loss of time or a loss in volatility, not to mention a drop in the price of the underlying security and other reasons. An option loses most of its value in the last 30 days, and the loss curve starts to accelerate during the last 60 days of its life. If the stock you bought an option on does not do exactly as you think it will and do it right away, time is working against you. If you buy an April option (the current month) and your stock waits a week before it makes its move, the stock could have stayed flat and you would be underwater as time decay eats away at the options' value. Even if your stock moves up, you could still see the option value decrease if the move was not strong enough.

We play positions that give us an edge: anticipated split announcement, pre-splits, signature patterns, breakouts and the like. Even with that edge, stocks can still move against you. If we bought near term options, if the stock does not perform as expected, at best you may break even if the stock rallies. You could make some money if the stock really moves back up, but it is always harder to recover lost ground.

Buying time gives us an edge as well. We like to see the breakout occur on signature patterns. If it fails, we have bought some time to ride the move out if we choose, though we prefer to cut losses quickly even with longer term options. Longer term options do let us ride out minor dips without losing much value. They also give us recovery time if unexpected news hits that causes the stock to gap lower. It is more like owning the stock, though it is still not the same as the option will ultimately expire.

In summary, buying longer term options gives us more options, so to speak. It allows us to decide if we want to ride a position out further without the emotional pressure cooker of knowing that each day takes a larger bite out of the value of our options. That emotion can lead to bad decisions. We want to eliminate that from the equation as much as possible. Owning a longer term option allows us to do that.

A long term option may not move as fast as a near term option, but if we are right about the move the stock makes, it will soon be far enough in the money to where the delta allows the option to move up more in step with the stock.


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