Trading time value

K

kmoney

This may seem like a ridiculous question so I apologize in advance. I'm still relatively new to options as I've only used them to hedge in the past.

Is it at all reasonable to sell an out of the money option farther out and to cover by buying a nearby option with the same strike? Once the nearby option expires you'd sell the farther out option or take delivery of it to eliminate risk. It seems like it would make a good theta play but I'm still a novice.

Would you please explain to me what I'm missing?
 
Have you considered back testing the idea to see what it yields ? Back testing has a lot of faults because it is only looking at historical data ... and like they say, it's no guarantee of future results, but it's usually better than nothing.
 
kmoney said:
This may seem like a ridiculous question so I apologize in advance. I'm still relatively new to options as I've only used them to hedge in the past.

Is it at all reasonable to sell an out of the money option farther out and to cover by buying a nearby option with the same strike? Once the nearby option expires you'd sell the farther out option or take delivery of it to eliminate risk. It seems like it would make a good theta play but I'm still a novice.

Would you please explain to me what I'm missing?
More...

Two things:
1) You example has you selling the far option to enter the trade, and then selling the farther option again to exit. Good work if you can find it. But,
2) What your describing is a calendar spread -- whether long or short depends on that sell-to-close/buy-to-close question.
3) If you're buying to close, you are selling the calendar -- which puts you at great risk if volatility grows, as it will hit your further (owed) option much more than your closer (owned!) option. [And so, some make a practice of, in times of low vol, buying calendars and hoping for a volatility pop.]
4) Diagonals work the same way, only more. (Thank you, Yogi Berra.)
 
There are several problems here. First, you can't sell an "out of the money option farther out" and close it by selling it again. So we start out wondering what your strategy is. Let's assumes that you meant that when the nearby option expires you'd BUY the farther out option it to close and that you are selling the calendar (horizontal) spread to open.

(1) Taking delivery after the near term option expires does not eliminate risk. It merely means that you then own (or you are short) the underlying. The option gains/losses will be imbedded in that position.

(2) Option premium is non linear so that means that nearer term options cost more per day than farther out options. IOW, in this short calendar you are losing more $$ per day on your near term option buy than you are making on your farther term option write. Share price stagnation hurts you. What you want is a large price move in either direction.

(3) Change in implied volatility will affect the further term option more than the nearer one so the next item on your wish list is a contraction of IV along with # (2) above. Either/Or, or both. If IV expands, your position suffers.

While it's probably above your pay grade, here's a learning curve example where the above might make sense. Company XYZ is announcing the results of clinical trials shortly but you don't know what the results will be. IV is sky high. Buy the ATM straddle of nearest expiration after the expected news date and sell the ATM straddle for a later expiration. After the news release, price should move dramatically and IV should implode, providing a nice profit in either direction. Be aware that if the news is delayed, you'll get clobbered so look at this as an example of understanding option pricing behavior rather than a recommendation for a position that you should attempt... unless you are under the supervision of an adult ;->)

Find an option program that graphs option positions (combos) and it's a real bonus is if you can vary the IV and the graphs provide time slices. A picture is worth a 1,000 words.
 
Kmoney, I've thought about this as well, but as they've indicated above, lots of risks. Just playing it out, you might buy a call with a strike of $10 that expires a year from now for $1, and sell a monthly call with the same strike for $0.25. You might think to yourself "well, I'll sell 12 monthly calls at .25, netting me $3, and all I paid for my yearly call to cover was $1 for a profit of $2."

The problem is if price spikes during the year. Price on the stock goes to $15. You get called out. You are down $4.75 on the call out ($5 less the .25). What do you do then? You are not down that much overall, as you had the long option, but now you are exposed. You might sell another call, this time with a $15 strike price, let's say for another .25. But what if the underlying drops to $10 again? You are down $4.50 overall.

My math might be bad but hopefully that makes some sense haha.
 
You must log in or register to reply here.
Back
Top