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Which Option Should I Buy\? -- Part Deux

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Which Option Should I Buy? -- Part Deux

Sometimes, I think the people that read my column are psychic. Last week we went through a graphic explanation of how to decide on which option to buy, whether ITM, ATM or OTM for a given option trade. As experienced traders know, that is only half of the question, as we also need to determine which expiration month to use. So after writing last week's piece, my intention was to cover the issue of expiration month this week. I guess I should have indicated that's where we were headed next, as I got several emails asking to cover the issue of which expiration month to utilize. I guess I better not disappoint.

Last week, we used IBM as an example using June put contracts showing that the perceived advantage of utilizing OTM options (due to their lower cost) may often be an illusion. In the example that we highlighted, even with a more than $10 drop in the price of the underlying stock, investors would have gotten more bang for their buck (in terms of %Return) using an ATM option than the "cheaper" OTM option. The theoretical reason for this is that the higher Delta of the ATM option allows the trade to start working in our favor earlier and at a greater rate.

In addition to picking the direction and severity of an expected move in the underlying stock, we also have to have an idea of the time period over which we expect that move to take place. If we are targeting a move over the next 2-5 days, then typically the front-month options will serve us well. But what happens if the move takes a bit longer, say 2-3 weeks? The depreciation due to time decay that occurs while we are waiting for the stock to reach our anticipated price target may exceed the appreciation resulting from the price movement in the stock. The net result would be that we are right in terms of the expected move in the stock but wrong on our timing, yielding a losing trade where a winner should have been. That's always a frustrating experience and I'm sure I'm not the only one that has gotten caught in that trap.

I'm a big believer in teaching by example, so let's dive right into a recent winning trade of mine and see if I made the best choice in terms of timeframe. Jeff Bailey got my attention with his recent bearish comments on shares of Williams Companies (NYSE:WMB), as the energy trader was looking very top-heavy under the continuing scrutiny by investors and regulators. Here's what the chart looked like when it first caught my attention.

Heavy selling had dropped the stock right down to the $15 level, which was just above major support at the $14 level. But with oscillators buried in oversold, I wasn't ready to take the trade. Looking at the PnF chart, I could see the double-bottom sell signal that occurred as the stock fell to the $15 level was forecasting an eventual decline to the $11.50 level. That gave me my target price and wanting to take advantage of both Delta and Gamma, I decided to select the $12.50 strike price, which would be ATM (maximum time value) if my price target was met. So what do we need next? How about an entry point? Sure enough, the market handed me one and I didn't have to wait very long.

A nice little rebound to the $18 level was all the bulls could manage, but that was enough to lift the daily Stochastics out of oversold territory. When that bearish crossover occurred on May 29th, it was time to enter the play. Aaahh, but that brings us the central theme of our discussion here today. What month options should I buy? We were already well into the June expiration cycle, so the June contracts were too short-term for my liking. When would the stock collapse under its recent lows? Would it meander lower or crater? Inquiring minds (Me!) wanted to know. Just in case it ended up being a long, slow grind lower, I opted to utilize August contracts. They cost me more up front, but I knew I would be fairly well insulated against the effects of time decay.

As you know from following the news recently, shares of WMB have absolutely collapsed in the past week, greatly exceeding my wildest expectations for the play. With one negative news event after another driving WMB to new multi-year lows, investors have been screaming "Get me Out!", which can be seen in the extraordinarily heavy selling volume on Monday and Wednesday of this week.

As I mentioned above, I was targeting the $11.50 level, and when WMB fell to the $11 level and stabilized yesterday, that was enough for me. I closed out my entire position, but after today's drop I'm wishing I had held on a bit longer. Seller's remorse hits again. So let's look at the relative performance of the $12.50 Puts for June, July and August and see how they fared. I'll use the closing price of 5/29 as the entry point and then look at the price of each of the options at the close on Monday (6/3) and today (6/5).

Expiration                   Price       Price       Price
Month          Symbol       (5/29)       (6/3)       (6/5)
June           WMB-RV       $0.25        $2.10       $3.00
July           WMB-SV       $0.75        $2.40       $3.30
August         WMB-TV       $0.95        $2.70       $4.00
Hmmmm. Looks like I could have done MUCH better with a more aggressive selection of June or July contracts, now doesn't it? Rather than the paltry 184% gain offered by the August contracts between 5/29 and 6/03, the June's would have been good for 740%!! But what would I have done with those June contracts if the stock had taken a couple more weeks to get moving? They would have likely expired worthless, keeping me from enjoying the profits of the play. July looks like the best selection from the data I've shown here, and I would have to say that I was a bit too conservative with the selection of August strikes. But given the chance, I think I would make the same selection, as buying plenty of time gave me the reassurance that I could be patient with the position while waiting for the forces of supply and demand to work in my favor.

As you can see, there are no hard and fast rules for which expiration month to select, as it is predicated on factors such as our expectations (which are basically an estimate), and the current market environment. As option traders, we strive to balance risk against possible reward, entering a given trade for as little as possible, while still giving ourselves enough time to be right.

As a side note, one of my early mentors in the option trading world advocated always buying 60-90 days of time when purchasing options due to the fact that it will keep you relatively insulated against the ravages of time decay while waiting for the trade to work in your favor. From my selection of expiration month, you can see that early advice is still exerting its influence in my trading decisions. And that may be the critical point to stress on the topic. Buy as much time as you need to feel comfortable in the trade. You may not make the killing that comes with buying front month options, but in my experience, sometimes a position trade with back-month options is the right choice to keep the account growing while we get our adrenaline rush day-trading front-month options on more volatile issues.

Best Trading Wishes!

Mark

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