Why Longer Dated Options Are Fundamentally Better
This is a shorter topic about the very common discussion of short term versus long term options. As a preface for people that are not familiar with options pricing, I’ll give a quick overview so the later discussion makes sense.
The pricing of options is a representation of the aggregate current and future value the option can provide discounted for the fact that future price action is completely random.
Let’s use a scenario to illustrate. Let’s say a stock trades at 100 and you bought a 100 strike call option. The value this option can provide goes up a dollar for every dollar the stock goes up. Now let’s compare different expirations.
If this option was dated for 2 years from now, you’d probably be willing to spend a lot more on it today because of how much potential there is for the stock to go up over 2 years. That would be drastically different if the option expired today. You probably pay much less because there isn’t that much a stock can do in a day.
Now what if the stock went down on this particular day? Well if you have 2 years left, a small daily blip probably doesn’t change your view much. However, if the option is only good for the day, there’s a much smaller chance of a recovery of the loss in just a day, so it would quickly become worthless.
So why does the difference in expiration date matter so much if everything is a zero sum game? Everything relates back to the discussion about consistency over immediate profit. The profit profile of a short dated option is right tailed distribution on the profit graph.
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The vast majority of short dated trades succumb to random day to day movement and decay far too fast to be of any use. Then there are the tail outcomes, where you happen to be holding the right contract during a strong move and see multi 100% returns.
You could equate this to playing slots–a large number of losses or tiny wins, all played in hope of eventually hitting the jackpot. It’s pretty much the same principle, and unfortunately has the same outcome, the loss of money. The point is, chasing the jackpot sinks you into a hole that the jackpot can’t make up for.
So what’s the key difference about long term options?
If you consider the probability distribution profile for a longer term option for any shorter time frame, any reasonable possible move is much less impactful. That is to say, a longer term option is priced for the expectation of greater stock price moves.
In the short term, we rarely see these types of moves because typically large moves happen over longer periods of time. That means that any singular random up or down day does not sway the option price that much. What might be a 300% gain on a short term option might only be a 30% gain on a longer term option. However, on the flip side, what would be a 95% loss on a short term option, might only be a 35% loss on the long term contract.
So how does the profit profile differ?
Long term options limit upside to limit drawdown and decrease the impact of randomness in the profitability equation. Essentially, you don’t get crazy profits on any singular trade, but you get a much more consistent profit profile with less unavoidable big losses. This aligns with the necessary trade profile for a successful trader.
If you don’t yet understand why consistency trumps big wins, please read my article about maximizing consistency
