Buying options is a risky proposition in itself. Options have a limited time frame and they will expire worthless if they are out of the money at expiration. Options are made up of time premium and intrinsic value. Options that are in the money have intrinsic value and they will be worth something at expiration.
The time value on an option is basically the premium you are paying for the time you have left on the option. The more time an option has, the more chance that it can increase in value. Options with less time are cheaper, but the window of opportunity is smaller. Buying more time costs more money and the market will have to make a larger move to make up for the extra money paid in time premium.
Benefits of Extra Time on Options
It is usually better to be safe than sorry when it comes to trading. Traders often find they are right on the eventual direction of a market, but their options expire worthless. It is usually better to sacrifice some potential returns from buying options with more time. If you expect a commodity market to move in the next three months, you might want to buy an option with six months of time until expiration.
Options typically decay in value at an accelerated rate in the last 30 days. Holding options during the last 30 days subjects a trader to options losing value very quickly. If you plan on being out of the trade well before then, the time decay might not be as extreme.
Buying long term options usually means options with at than 3 months until expiration. However, I classify long term options as having 6 to 12 months until expiration. A trader can do very well buying these options when the volatility levels are very low. That means option premiums are relatively cheap. If the market becomes very volatile after you buy the options, the premiums could shoot higher. Professional traders can make a good living buying options with low volatility and selling options with high volatility.
Pitfalls of Long Term Options
The luxury of having more time to make money means you will have to pay for it. This means you will have to pay a much higher price for an option that has 9 months of time value compared to an option with the same strike price that has 1 month.
In this case, the underlying futures contract will have to move much more to make the same type of returns as an option with little time value. Theoretically, you will have more time for this to happen so it could even out in the end. The problem is that the market could make a nice quick move in your direction, but the options haven’t increased much in value. This can be frustrating at times, because options with a lot of time premium often aren’t very tradable.
Many traders often compensate for the extra cost of time premium by buying options with strike prices that are further out of the money. This can work great if the market makes a big move higher, but it is often a mistake. Options that are far out of the money are usually a crapshoot. Most of the time they expire worthless even though you bought a lot of time.
There are many strategies with long and short term options. The bottom line is that options are priced to reflect all of these pros and cons. It doesn’t matter what option you buy or sell, it will reflect all the variables that determine an efficient price. The important factor is to choose the correct option for your particular market strategy.