One of the most important questions new options traders ask is:
How to pick an options expiration date
“Should I go for something short-dated, or should I go for something long-dated?”
It’s a good question, and depending on the strategy, one expiration date may actually be better than another. But there’s one thing about option pricing that you must understand to help you decide which options expiration date to choose.
When most option traders ask about what the best timeframe is, what they’re really asking is which type is the most “worth it”…
Most traders intuitively assume that longer-dated options cost more money. And that’s true, since more time allows the underlying stock price to move closer to your strike price.
For instance, imagine you wanted to buy an option at the $100 strike price. If you compare the January expiration date to the March expiration date, you know that the March $100 strike call will cost more money. However, the question becomes: Is investing in the extra time value worth it?
Let’s start with a smaller question that will help you determine how option prices change as you alter expiration dates.
Level Up Your Trading
Get a custom-designed trading program tailored to your individual needs, skill level, and schedule.
Does having twice as much time (between expiration dates) make options cost twice as much money?
The short answer: No.
Here’s why:
In the world of options, there’s an interesting mathematical connection that says it takes about four-times the amount of time (as in, time before the contract expires) to double an option’s price. (Note: This applies for at-the-money options only.)
The reason for this option-price-to-expiration-date relationship is that option value is proportional to volatility, and volatility is proportional to the square root of time.
So, it may sound confusing, but you should know that there is at least a method to madness — a very strong reason for this relationship. If this is getting a little abstract, have no fear! Let’s take it step by step with an example.
How do options expiration dates impact option prices? Example 1:
Let’s say that we have an option contract that costs $1.00 with an expiration date one month away. If this one-month-to-expiration contract costs $1.00, how much does the corresponding four-month-to-expiration option cost? It has four-times the amount of time — but is it four-times as expensive?
Here’s how we would figure it out.
Notice that the one-month options expiration compared to the four-month options expiration, again, is four–times the amount of time. All you have to do is take the square root of this number (the square root of the difference between the two expiration dates) and you now have the most important piece. This number right here, the square root of four (which is two), tells us the scaling factor for the option price. So, now that we know that this second option is going to be two-times the price of the first option (which cost $1.00 dollars), we can expect that the four-month option contract would be trading for about $2.00 dollars.
Let us show you how to find Unusual Options Activity
Everything you’ve ever wanted to know about Unusual Options Activity—in one convenient insider’s guide.
So then which expiration date is really more expensive? On one hand you might say that the four-month option would be more expensive, because $2.00 is greater than $1.00. But let’s look at it from another perspective. The first option costs one dollar per month ($1.00 divided by one month until the expiration date), while the second option costs only $0.50 per month ($2.00 divided by four months until the expiration date). That means from the perspective of time value, the longer-dated option is actually only half the price.
Let’s try another example.
Option expiration dates, example 2: 1 month versus 9 months
What if we had a one-month-to-expiration option trading for $5.00 dollars. How much would the 9-month-to-expiration option be worth? What would you expect it to be trading for?
First, notice the obvious: Between the first expiration date (1 month) and the second expiration date (9 months), there is nine-times the amount of time. The square root of that number — of the difference between the two expiration dates — gives us our option price scaling factor. In this case, the square root of nine is three. So we would expect that the second option, the option with an expiration date nine months out, would be three-times the value of the first. And because the first option is trading for $5.00 dollars, we would expect the second option to be trading for about $15.00 dollars. Notice the second option is three-times the price of the first, not because it has three-times the amount of time, but because it has nine–times the amount of time.
Which option is cheaper? The short-dated option or the long-dated option?
On a dollar-for-dollar basis, the option with an expiration date one month away is technically cheaper, because $5.00 dollars is less than $15.00 dollars and the strike price and underlying stock are the same. However, on a dollar-for-time basis, the longer-dated option with the expiration date nine months away offers a better value. Once again, this is because the nine-month option costs only $1.66 dollars per month, and the one-month option costs $5.00 dollars per month. From a time-perspective, the nine-month option is just 1/3 the price of the one-month option.
So then, here’s the answer to the options trading question you actually care about:
What is the best timeframe for options trading?
All things being equal, option traders should usually buy longer-dated options with a strike price near the underlying stock price, as they often become progressively better deals. On the other end of the spectrum, option sellers should look to sell shorter-dated options with a strike price farther from the stock price, as they experience a faster progression of theta decay (time decay).
Are there exceptions? Absolutely. Mastering options will help you identify those instances where it’s better to buy short-dated options. But for starters, the main point to understand is that buyers shouldn’t shy away from longer-dated options just because they appear to cost more money. On a per-day basis, they’re actually cheaper to own.
Ready to take your trading skills to the next level? Check out the Rebel Blog for more free options trading tips.
