Too many traders avoid buying options for one simple reason – time decay.
Every second that passes where the trade isn’t working in your favor creates anxiety—because as you know—if it stays out-the-money, those options will expire worthlessly.
I believe for some, the difficulty lies in that they’re not considering the time element in their decision-making process… A BIG MISTAKE.
After all, when you’re trading stocks, you’re primarily focused on price action and volume.
But believe it or not, making the decision on whether you should be buying weekly options, or later-dated contracts is not as trivial as you may think.
Today I’m going to teach you how to connect the dots.
More specifically, how to pinpoint the right options contracts to trade so that you can minimize risk while maximizing your potential returns.
No matter how you trade, time frame selection tends to come down to a few different types – long-term, multi-week, multi-day, intraday, and scalping.
For the majority of us, the long-term trades come off of the weekly and even monthly charts. Multi-week trades tend to come off the daily charts. Multi-day trades look at some hourly or multiple hour charts. Intraday time frames look at fractions of an hour. Scalping looks at something 5-minutes or under.
Picking the correct option expiration starts with the time-frame you set up the trade. To give you an extreme example, you don’t want to select options that expire at the end of the week when the trade could take a month to play out. Nor would you want to choose options that expire in 90 days for an intraday scalp. My goal is to find a balance between the two.
Pick the expiration 2x-3x longer than you expect the trade to take
This rule of thumb works really well when selecting the correct option expiration. If I think the trade could take a day to play out, I want to take the weekly options for either this week or next week, depending on when I initiate the trade. With scalps, I’d choose weekly options that expire on Friday.
When you get to higher time frame swings, give yourself more latitude rather than less. If you think the trade could take two weeks to play out and you’re stuck between the options that expire in four weeks or six weeks…go with the six. You may give up some profits on a few trades. But you’ll be happy when that one trade takes a bit longer than anticipated to play out.
Do you know how long your trades take?
All of this assumes you know how long your trades run. In fact, most traders don’t really have a notion of how long they should expect.
I learned two things over the years that help me out. First is my LottoX indicator. This helps me identify places where time is running out, and an explosive move should happen soon.
Second, and this is more important for you, was my trade journal. I used my trade log to tell me how long my average trade took. This was before I developed my timing indicators. It’s a cheap, easy way to determine how long your trades should take. If you’re working a completely new strategy, then do some simulated trades or look back through some charts to get an idea of the typical length.
Expiration goes hand in hand with strike price
Your expiration is only one part of the equation. Strike price plays an equally important role. The deeper in-the-money the strike, the more expensive the option, but the less you lose to time decay.
I prefer options that are a strike or two in-the-money. That gives me enough movement for my option without having to worry as much about time decay. I pair that with the expiration that provides the trade with just enough time to play out, and I’ve got a winning combination.