What do you do when your setup is still valid but your option expiration closes in?
This is a common LottoX situation because I play short-dated options.
And one that deserves an explanation.
Because if the setup is still valid, then there is only one thing that should matter – time decay.
You see, when I’m long options, time decay works against me.
So if the setup takes too long to play out, I could end up losing on the trade.
That’s why I start by asking myself the following question –
Would I take this trade now if it was brand new?
If I answer no, chances are I suck it up, take a loss right then and there and move on.
Which I know is extremely difficult for many of us.
But if the answer is yes…
I go through the following steps.
First things first, am I trying to defend a trade when my stop loss was already hit?
I know this is redundant. But believe me, we do plenty of mental gymnastics to avoid taking a loss when it’s the best option.
I only defend my trades when they meet three criteria:
- The setup is still valid
- Neither my stop nor target has been hit
- I would take this trade right now if I had the opportunity
The only thing that should be preventing me from continuing with this trade is time decay.
You see, when I own an option, they lose value at an accelerating rate.
That value is known as the ‘extrinsic value.’
Intrinsic value is the amount your option is in-the-money (difference between the current price and the strike price).
Anything beyond that in the option price is extrinsic value.
Here’s a look at how time decay works.
You can see how the closer an option gets to expiration, the faster it decays.
When I play short-dated option setups that take too long, I risk getting hit with too much time decay.
So, if I want to extend this trade, then I need to look at it as a fresh setup.
Keep in mind, since the initial setup is still intact, chances are the setup now appears on the next time frame up.
And since the timeframe determines my choice in expiration, I want to check and make sure.
For example, if the original setup was on the 30-minute chart, it may now exist on the 78-minute chart. That changes option contract expiration I choose.
Defense 1: Rolling options
Rolling an option sounds harder than it actually is.
All I’m doing here is closing out one trade and opening another simultaneously.
Let’s say I was long the $100 Apple calls that expire this Friday.
I want to give them another week to work.
So, I go in and sell to close my current options while buying the $100 call options for next week at the same time.
When I roll long options it will almost always cost me money since the only thing I’m changing is the expiration date.
And as we know, the further out in time you go, the more expensive an option becomes all things being equal.
There are rare exceptions to this when a change in implied volatility offsets the increase in duration.
Defense 2: Hedge the position
Hedging a position is a fancy way of saying reduce your risk.
When trading options, risk comes in three different varieties – duration (time), direction, and volatility.
We’re going to focus on duration risk since directional risk tends to lead to stop outs anyhow.
With time risk, you lose money every day that you hold a long option.
So, you have two choices:
- Roll the option out to cut down on the speed of that decay
- Sell an option that pays you what you’re losing in time decay
Selling options aren’t for everyone. But, it can be an effective tool to balance a portfolio.
Let’s use the Apple example from above.
Say we have $5 in extrinsic value that will reduce to nothing by Friday.
I can sell an option on Apple or another stock that pays me the same thing I lose each day.
With options, there are numerous ways to structure trades because of their flexibility.
And it’s why I absolutely love them.
Seeing it in action
You’re probably wondering what this LottoX thing is I keep referring to.
It’s my premiere options education service aimed at making you a better trader.
Not only do you get my trade alerts and a streamed portfolio, but a daily analysis before the market opens.
You’ll know what I’m looking at, where I’m looking for it, and why…
All using the same techniques that helped me turn $38,000 into over $2,000,000 in just two years.