The Risky Allure of Short-Dated Options

Articles From: Interactive Brokers
Website: Interactive Brokers

By:

Chief Strategist

Interactive Brokers

For those of you who still get actual newspapers, this story ran on the front page of the second section of the Wall Street Journal: Traders Pile Into Boom-or-Bust Options to Play Stock Market Volatility (It was posted online late Tuesday.) The reporters noted the increasing popularity of short-dated options, noting that about half of all activity in the options market occurs in options expiring within a week or less.

I was fortunate to be among those asked to comment for the article, and the first quote they used was “speculators love them” [short-dated options]. I stand by the comment, but I want to use today’s piece to expound upon the thoughts I presented.

There are valid reasons why speculators have gravitated to short-dated options. For starters, the time premium is minimal, so they tend to trade at lower prices. But it is important to remember that a lower price doesn’t necessarily mean that the option is truly cheaper. The shorter-dated option may have a higher implied volatility. Sometimes that is for good reason – especially if an event like earnings is expected – but sometimes it could simply be a reflection of higher demand from traders.

Also, the reduced time premium hardly means that it can be ignored. Options decay over time; that decay is represented by the Greek letter “theta”. Of course we would expect theta to represent a smaller component of an option’s price as each day passes, but the effect of the residual theta is magnified. Theta is non-linear, and accelerates as we approach expiry. One of the first lessons I learned when trading options was that “time decay falls off a cliff in the last week.” If you’re buying options with a low theta, that doesn’t mean that you won’t find yourself fighting its effects anyway.

Those of you who are inclined to write options will recognize that this can present an opportunity – and many have. As speculators gravitated to short-term, out-of-the-money calls in 2020-21, pushing up the implied volatilities of those options, some of that demand was met by covered call writers. If you’re writing calls for income – thus attempting to profit from theta — you might find it more appealing to write weekly calls four times a month rather than writing one one-month call.

Timing is always crucially important when trading, and especially so when trading short-dated options. The risk/reward calculus is magnified and accelerated. A well-timed short-dated call or put purchase can lead to quick profits, but also allows the option to expire worthless more. On the flip side, a seller can reap premium income faster and more frequently, but short-dated options expose a covered seller to a greater likelihood having the stock called away or put to them and/or raise the naked writer’s chance for an exponential loss.

Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers, its affiliates, or its employees.

Disclosure: Options Trading

Options involve risk and are not suitable for all investors. Multiple leg strategies, including spreads, will incur multiple commission charges. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD) or visit ibkr.com/occ