Alan Ellman of TheBlueCollarInvestor.com addresses the pluses and minuses of entering option trades on the Monday following versus actually on Expiration Friday.
The timing of option trade executions will impact the success of covered call writing returns. The BCI methodology prides itself on having rules and guidelines for buying back options, re-selling options and selling long stock positions. One question that many of us have thought about is when to enter our 1-month trades.
- For a 4-week contract ( 8 of these per year), we enter the trade within the first few days of the contract
- For a 5-week contract (4 of these per year), we enter the trade within the first seven trading days of the contract
The reason we don’t want to wait longer than these timeframes is due to the impact of theta or time value erosion. Theta is an estimate of how much the theoretical value of an option declines when there is a passage of one calendar (not trading) day while there is no change in stock price or volatility. For near-the-money strikes, theta is logarithmic in nature (not linear) and causes time value erosion to start off slowly and then impact our premiums more as expiration approaches as shown in the chart below.
Click to Enlarge
With this in mind, many covered call writers intuitively feel that they should establish new positions on expiration Friday, rather than the following Monday, to capture some extra time value and negate the impact that theta will have over the weekend. To see if this approach will benefit us in most cases we must further investigate how traders value the options when using option pricing models. For every calendar day that passes, the option value will decline by the amount of the theta. To really dissect this in a blue collar manner we must ask ourselves when the calendar day is deducted from the pricing model…Friday…Saturday…Sunday…once each day?
It is fair to say that many traders assume the day is deducted and option premium value is decreased at the end of each calendar day and base their trades on that assumption. However, that frequently is not the case as traders anticipate the price decline and calculate option value prior to the end of a trading day or prior to the weekend. We may notice option values declining on the Thursday before expiration Friday and more so mid-day on expiration Friday as options are now being priced at Monday’s theta value. In other words, the weekend days are already deducted and so there may be no added value of entering trades on expiration Friday compared to the following Monday. In addition to this, we are now exposed to weekend risk for very little reward, if any at all.
Of course, there are many other factors that impact option value (the Greeks) so we can’t make a blanket statement that we are always better off waiting until Monday. However, we can say that based on the manner in which theta is factored into option value, waiting until the beginning of the week after expiration is generally a better way to enter new covered call trades.
By Alan Ellman of TheBlueCollarInvestor.com
