Understanding Time to Expiration in Options

Understanding Time to Expiration in Options


Understanding Time to Expiration for Options is one of the great misunderstood inputs in the Black-Scholes Model.  The option goes through a metamorphosis not unlike a butterfly, no pun intended.

Larva, does not move much, Caterpillar, moves some, Butterfly, moves a whole lot

Phases of Options

The Time Frame a trader puts on the option should be connected to the duration of the event they have in mind.  So If I was a long term investor, Caterpillar Effect, in $WBA, which I am, I look for ways to get long the stock that I think will outperform the shares over a longer time horizon of 6 months.  If I think this market is going to move big over the next several days, I will trade a relatively short term strangle since I want the gamma, Butterfly Effect.

Chart by Vixcentral.com

Reading Realized Volatility

Right now everyone is asking if the bottom is in.  I will say how long does the trade have to wait?  Is the trade short term with very high implied volatility or longer term at somewhat high volatility?  If you took our classes on VIX and VXX you would notice the VIX futures curve and what it is telling us.  Right now the market expects higher volatility short term and less volatility after the election.  Even with the lack of broad market realized volatility, SPX, volatility today,  QQQ is still high at almost 2% ATR.  One sector of the market is holding up the implied volatility in the other.

Trade Creation

Putting on trades right now has to be in the  time frames, into the earnings cycle, through the election and after the midterms.  Each is a separate time frame with a separate time to expiration.  The big mistake is creating an election trade that expires Friday or an earnings trade that expires in February.  Having the cycle and idea generation so far apart is problematic.

The $VIX curve thinks $VIX will get crushed into the election but $SPX could blow up tomorrow.  There is a trade for that.  Tune into our Saturday class on Weekly and Daily options this Saturday and learn how to do it.

Disclosure: Positoins in $VXX, $VIX, $SPX, $SPY, $WBA

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