Before selecting an expiration date on an option contract, it is important to review some basic concepts of option trading.
Remember that the premium of an option is defined as a tangible value, determined by the relationship between the strike price and the price of the underlying stock (also called the intrinsic value) and by a time value, which is interpreted as a measure of the value of market uncertainty.
The more uncertainty there is concerning the underlying’s future value, the greater the (time) value of the option, and vice versa.
So how can we select an effective expiration date on an option contract?
This will depend on several factors:
To help us make this decision, we will now look at a variable that is key to assessing the premium on an option: the Theta coefficient.
Theta is the coefficient of the sensitivity of an option’s premium to the passage of time.
It measures the negative impact of the decaying time factor on the option’s premium.
You can obtain Theta using the option calculator found by clicking here:
Selecting an expiration date: Basic concepts
Options with shorter-term expirations may be preferred when there is a marked change in the price of the underlying.
Options with long-term expirations can be part of an option writing strategy, to benefit from the high premium, or at a time when the market is consolidating or stable.