Some thoughts on the near term vs longer term debate:
Subtitle: Debunking the myth of square root time value erosion? <ggg>
Several recent posts have called attention to the fact (yes it is a fact, under the right circumstances) that the price of an option decays more rapidly as expiration approaches. Those who are really careful about it add a qualifying statement like "all else being equal" because it is under that circumstance, or a fair approximation to it where the statement holds true. Others have argued that the longer time frame is more relaxed, and actually can afford better opportunity for profit. Who is right?? Well actually, they both are.
If the price of the underlying did not change very much with time, the price of a near term call would drop faster than the price of a longer term call. Such behavior is a reasonable expectation for a low volatility stock over a month's time. But it is often not a good assumption for higher volatility stocks.
Regardless of which expiration month you choose to write, all CC positions start out with the same net value, what you would receive if you bought back the call and sold the stock (neglecting bid-ask spreads; we are talking theoretical here). What is different is the ultimate profit loss envelope at the respective expiration dates, and the evolution of value with changes in time and underlying price. For OTM calls, the initial rate of change of the position value with stock price is greater for near term calls than it is for longer term. And it works both ways; the value drops faster if the stock declines and goes up a bit faster if the price rises. The difference widens for a price decline, but or an up move the difference is small; the value of the CC with the longer term call will catch up to and outpace the near term call for a big enough move. So in the case of a rather sudden drop, or a large increase in the underlying price, longer term calls are more favorable than short term calls. Time value of a call can be more strongly influenced by a change in the underlying price than by the mere passing of time.
The fair comparison to make is the one that corresponds to the strategies people usually employ. So the question is, which strategy puts you in a better position on expiration day of the shortest term call you are considering. To make the comparison you need to know how the price of a long term option evolves, so you need a model. Here is one example:
QCOM volatility is around 61%, and its near term ATM options are actually selling at a bit of a discount, which tends to disfavor the near term calls. To be more fair, and to simplify, consider the theoretical prices as of July expiration Friday, and compare buy-writes at $65 with theoretical option prices for AUG65 (4.50) and JAN65 (11.80). At August expiration, the range of closing prices for which the AUG65 CC has greater value than the JAN65 CC is from about $58.50 to $76. But, when you are looking in the >65 (above strike) range you have to consider that you are going to be called out, and if you feel you must own the stock you have to buy it, or the calls back at a higher price. At 67.50 the cost to getting back in would negate all advantage of the AUG65 CC, so the range is really from about 58.50 to 67.50. Then there is the fact that if you write every month you have more transactions costs, and may lose some premium to the spread. Plus, if at any time during the month the price moves below this favorable range, the JAN65 provides an opportunity to lock in more "time premium" gain than you can ever achieve with the near term calls.
So which is really better? There is no one right answer. Both sides have good reasons for favoring their approach. For those who are willing to be called out and let a stock go if it does not come back to them, and are comfortable that the stock is not going to fall below the bottom of the favorable range, near term calls are best. For those who don't want to be so active, or are concerned a significant down move is lurking in the next month, the longer time frame really is better. It happens that during the past two weeks QCOM fell out of the range that favors the near term calls. If those who favor the long term approach were agile enough, they had opportunity to do better than the near term sellers. Some months it happens that way. Some months it does not.
Dan |
