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3 Key Methods For Trading Options Close To 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.

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.

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.

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.

Two problems with longer-term expiration: First, this leaves you exposed longer, meaning a greater chance of exercise. Second, return is not as great. Check it out. Compare six two-month covered calls in a year, versus one 12-month position. The shorter the term to expiration, the greater your annualized yield. This is because time decay is at its fastest in the two-month window.

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