The best time to open a short trade is the Friday before expiration. With only one week to go, there are seven calendar days remaining, but only five trading days. With time decay accelerating rapidly, the typical option loses one-third of remaining time value between Friday and Monday in this crucial week.
One trading technique combines several attributes about opening and closing the short trade:
Pick a strike at the edges of the trading range. Sell calls when price is at resistance or better yet, when it gaps through resistance. This is the most likely time for reversal, especially if price also moves above the upper Bollinger band. Sell puts when price declines to support or gaps below; again, if price declines lower than the Bollinger lower band, timing to enter is excellent.
Pick a strike at or out of the money, but not too far out. Maximum premium will be earned when the proximity of strike to the current underlying price is close.
Pick expiration one week away. Friday is the ideal day for opening a trade. Aim for a one-week holding period at the most but be willing to close any time in the coming week.
Set a goal. Will you buy to close your short option when half of its value has gone to time decay? Or do you require 1 100% profit, meaning waiting for expiration? Without a goal, you have no idea when to buy to close.
Follow your goal. When the option’s value has declined to the level you have identified, get out of the position.
- Even if you have set the goal for expiration, consider closing on expiration Friday and replacing the position with the following week’s expiration.
To this final point: Should you buy to close on expiration Friday?
In fact, there often is very little justification for waiting out expiration, even if that was your original goal. If the option is out of the money, it will expire worthless; if in the money, you risk exercise by holding on to the contract.
Buying to close on expiration Friday makes sense for many reasons. Even when the position is out of the money, what if the option moves just before close and ends up slightly in the money? It will be exercised. Because it was close to no value, this consequence of waiting makes the risk unacceptable. Closing and taking profits is the rational choice.
Another reason to close on expiration Friday is that it frees up your collateral to sell another option, one expiring the following Friday. This assumes that the six points listed above still apply. You must review the current underlying price and strikes, and check proximity of price to the upper or lower Bollinger Bands (or other signals you might prefer to use).
Also check momentum. Relative Strength Index (RSI) may be the most consistent and reliable test of coming reversal. Look fort movement into overbought or oversold, which confirm what you see in Bollinger Bands signals. Combine RSI with other signals as well, including volume spikes or strong candlestick reversals (engulfing, three white soldier or three black crows, morning or evening stars, hammer or hanging man, to name a few). The more confirmation you find for reversal signals, the higher your confidence is in the likelihood of reversal.
The strong reversal signal is likely to occur on expiration Friday, when option premium tends to peg to the underlying price, meaning it is likely to move to the closest expiration. This is one example of the option market’s influence on stock prices, but it occurs primarily on expiration day. Friday is an excellent opportunity to close a short position and take profits; and to then replace the position with the option expiring the following week.
If you do close the current option on Friday and replace it, what is the best timing? Some traders like to make decisions first thing in the morning; others prefer last-minute trading. But regardless of personal preferences, the best time to trade is when conditions favor maximum profit. If your short option is out of the money by mid-morning, get out while you can still get maximum benefit. Things can change rapidly; and on expiration Friday, a slow morning could be following by a volatile afternoon, including reversal of direction. This is where many options traders lose money. In hindsight, they should have bought to close before the lunch hour, but they did not anticipate losing the advantage they had being out of the money.
This is a problem that potentially recurs every Friday. Because prices change rapidly on this day, get out when you have profits. Fridays are unpredictable not only because of the option expirations, but also because the weekend can mean big changes. Traders want to close out positions rather than holding them open through the weekend, and this applies to both long and short equity positions, as well as options.
The next question is, when should you sell to open the new option? If the morning presented an opportunity to take profits, it could also present an opportunity to open a new short trade with a different strike. Base timing on Bollinger Bands if the underlying is volatile. Once you are out of the original position, you can time a new one any time you want – same morning, later in the day, or just before the close.
Timing. It is all a matter of when to take profits or cut losses, and when to replace the original position with another.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
There are no comments to display.
Create an account or sign in to comment
You need to be a member in order to leave a comment
Create an account
Sign up for a new account. It's easy and free!
Register a new account
Already have an account? Sign in here.
Sign In Now