In my last option trading blog, “Buying In-The-Money Options – A Hidden Benefit” I described the advantages of doing so. I did not write about which month to buy. As with all option trades, your opinion of the underlying move will determine the strategy. If you are looking for a longer term move, a back month option usually makes the most sense.
Let me use the previously referenced PCAR trade I did in April. I felt the stock could move $10 higher from it’s price of $72 over a period of months so I bought the August 65 calls for $9.80. I bought ITM options so that I could realize gains on a small move and “jump off” at any time if I wanted to. I also felt the stock was just above strong support and $9.80 “rug” would not get pulled from under me. A back month option displays the properties I discussed in the last posting, but to a greater degree than a front month option. If my assumption was wrong and PCAR fell, the options would implode with time premium and retain more of their value.
Imagine that PCAR dropped in a day and it traded down to $65. A May option that would expire in a few weeks would retain some value, but not as much as an option that expires in another 3 months. The reason for this is that there is time for the stock to “snap back” and an earnings release was due within that time frame. The uncertainty that caused the supposed sell off would actually help the option retain value and the company would have a quarter to correct the problem. Mind you, the hypothetical event stinks because I’m losing money on the trade.
Back to the original line of thought. The move was going to take place over a few months so I had the latitude to look at back month options. What if I was just looking for a $2 gain to unfold in a week? In that case, given the wide bid/ask spread in the options, I would have traded the stock. If you are looking for a $2 move and there is a $.30 bid/ask spread, you are giving up $.60 out of your $2. Don’t line the Market Maker’s pocket. You are giving up too much edge. For the same reason, you don’t buy front month ITM options and “roll” them each expiration. There is too much slippage. Usually, a back month ITM option won’t cost you that much more ($1-$2) and it has a big benefit.
When you buy back month ITM options – you can sell front month premium against them to generate income and take advantage of accelerated time premium decay. In the case of PCAR, the stock ran up and I was able to sell the June 80 calls for $1.30. There was no margin requirement since I owned a deeper call with more time and it generated free cash flow. The stock was holding up well in a declining market so I did not want to close the trade (sell the august 65 calls). I just wanted to take in some premium and add a little protection. The June options expired and the stock rallied again. I could have sold July options against the position, but I did not like the market action and I decided I needed more protection. I sold the August 80 calls for $3.70. Now I’ve collected $5 in premium and I own a 15 point August 65 – 80 call spread for $4.80. The stock is at $77 so it has been a nice trade. It has spent a lot of time over $80 recently and with a little help from the market it will get there again so that my Level 3 Option Reportsubscribers can “max out”.
One note of importance! If the June 80 calls had finished in-the-money, I would have bought them and sold the August 80 calls.
Remember, if you’ve found a longer-term grinding move of $5 or more on a stock with good support, back-month ITM options. During the PCAR trade, I legged into a diagonal spread. In the next posting, I will use the strategy as an entry position.
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