Depending on the strategy that you are trading for your portfolio, there are different ways to select expiration dates and strike prices that are suitable and optimized for each strategy. This blog post will cover how to select the right expiration dates and strike prices for any strategy so that you can make better informed decisions for your trades. 

Expiration Dates

The chart below shows how the option price declines as the options gets closer to expiration. This is known as Theta (time-decay). With everything else held constant, the rate at which time-decay eats away at an options value increases the closer it gets to expriation (time decay is not linear). A 3-month option will experience less time decay than a 3-week option. This is an important concept to understand and plays a big factor in deciding which expiration dates are best suited for your strategy

Choosing the optimal expiration date for your strategy depends on whether you are buying or selling an option. The best practice when selecting expiration dates for buying an option is to choose longer dated options. This is because longer dated options decay at a slower rate (minimizing Theta) compared to a shorter dated options that has a higher Theta. In other words, with everything else held constant, a 3-month option will lose less of its value compared to a 3-week option over the same time period. However, shorter dated options are cheaper than longer dated options are therefore more tempting to buy than a longer dated option, but their profits are eaten away at a faster rate. When selling options, shorter dated options are preferred. This is because Theta works in favour of the options seller. The seller of the option receives the premium paid and hopes for the option to expire worthless to keep that premium. The faster the option becomes worthless, the better it is for the option seller. Because shorter dated options are cheaper than longer dated options, it may be tempting to sell longer dated options. However, the premium received in respect to time from selling an option is not linear – if a 30-day option costs x, a 60 day option will cost something like 1.5x. Even though the length of the contract doubles, the premium does not. This means it is actually more profitable to sell two 30-day options instead of one 60-day option over the same time period. 

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Strike Prices

The chart below shows the relationship between options with different strike prices and the rate at which they lose value as they approach expiration. In the money (ITM) options have very low time-decay due to their low extrinsic value. Out of the money (OTM) options have the most time decay as they only have extrinsic value. Options that are at the money (ATM) will become ITM options if the trade goes in its favour and will therefore have less time-decay. 

When buying an option, the goal is for the option to increase in value. Strike prices that are in the money will be the least impacted by Theta and therefore less of the option’s value is eroded. Slightly ITM strikes generally work best when buying options. When selling an option, OTM options work best as the goal of the option seller is for the option to expire worthless and OTM options are impacted the most by time-decay. 

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Optimal Expiration Dates and Strike Prices for Income Strategies

1. Covered Calls – A covered call is an option strategy used to generate income on stock that is already held in the investor’s portfolio. This is done by selling OTM calls against the stock. The investor will receive income in the form of premium. If the contract is exercised, the investor will be able to sell the stock at the strike price thus gaining a capital appreciation on the stock. Best practices:

• Expiration Selection - 30-45 days. 
• Strike Selection - 15-20 Delta (Far OTM) - 15 to 20 Delta means that only 15-20% of the time, strike price will be reached.

2. Short Puts – An income and stock acquisition strategy. Selling puts allows the investor to receive income via premium while also giving the opportunity to buy the stock at a discount at expiration. Best practices:

• Expiration Selection - 30-45 days.
• Strike Selection – 40 Delta (Slightly OTM). This gives a higher probability of the contract getting exercised by the buyer allowing the seller to buy the stock at a discount.

3. Selling Credit Vertical Spreads – This strategy is an improvement to selling naked calls are puts. A credit spread is selling an ATM option and buying an OTM option. The long leg offsets some of the premium received but also places a cap on the risk. Best practices:

• Expiration Selection – 30-45 days
• Strike Prices – sell leg: 50 Delta (ATM), buy leg: 25 Delta (far OTM)

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Optimal Expiration Dates and Strike Prices for Directional Strategies

1. Buying a call or put best practices:

• Expiration Selection - 45-60 days or greater
• Strike Selection – 50-60 Delta (slightly ITM)

2. Debit Spreads – A debit spread is an improvement on buying a naked call or put. It involves buying an ATM option and selling an OTM option. This creates a cap on the reward but reduces the cost of the trade as the premium received from the short leg will offset some of the premium paid on the long leg. Best practices:

• Expiration selection - 45-60 days or greater
• Strike prices – buy leg: 50-60 Delta (slightly ITM), sell leg: 15 Delta (far OTM)

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Summary

When it comes to expiration dates and strike prices, the best practices vary depending on whether you are buying an option or selling an option. These best practices are summarized as follows:

Expiration Dates

• Buying – Longer dated (1 month or greater)
• Selling – Short dated (less that 45 days)

Strike Prices

• Buying – At the money or slightly in the money
• Selling – Out of the money

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