Options Forum: Expiration Effects

Do options purchased further out from expiration move up and down less than options purchased closer to expiration? I bought some in-the-money Nasdaq 100 Trust ( QQQQ) puts with an expiration in June. They do not seem to have moved up as much as the market has moved down.

-- WC

It's funny: The subject matter of reader questions seems to come in cycles. Maybe it has to do with market action or maybe it's a function of this column having marked its two-year anniversary, and I'm simply seeing new readers come aboard.

In any case, this is good because it says that issues, obstacles and uncertainties that have plagued investors in the past continue to do the same now.

It's no wonder that books such as Reminiscences of a Stock Operator by Edwin Lefevre and Option Volatility & Pricing Strategies by Sheldon Natenberg remain bestsellers decades after their first publication.

The answer to the question above, as always, is "it depends."

The first thing in comparing options is to make sure we are dealing with the same strike price. The reader's reference to "further out" options means those with a longer life span or later expiration date, not options with strikes priced further out of the money.

Here is where the ever-present "it depends" comes into play, forcing us to apply all kinds of qualifiers and caveats before venturing an answer.

These are things we need to know: How far in or out of the money are the options? How much time is in each contract, not only in relative terms or the differential between the two options, but the absolute number of days remaining, especially regarding the short-dated options? And of course, what are the relative levels of volatility, and is there a skew?

The table below illustrates values and price moves for QQQQ put options across various strikes and expirations during Thursday's decline of 73 cents, or 1.90%, to $37.35 in the underlying ETF.

Value, Change in Price and Delta for Various QQQQ Puts on Jan. 20
Jan. Exp. Value Price Change on 1/20 Delta
$36 $0.05 n.a 0.02
$37 $0.10 $0.05 0.04
$38 $0.65 0.35 1
Feb. Exp.
$36 $0.30 $0.10 0.08
$37 $0.65 $0.15 0.34
$38 $1.05 $0.35 0.71
June Exp.
$36 $1.20 $0.05 0.21
$37 $1.65 $0.15 0.36
$38 $2.10 $0.25 0.53
Source: TSC Research

When there is very little time remaining, out-of-the money options barely respond to large price moves in the underlying security; options with more time remaining will show a marked increase in value. For in-the-money options, the near-term options, because they are basically trading on par with the underlying security, will therefore be more sensitive to those moves and show a larger price movement. Looking at options delta is always a great first step toward gauging the expected price movement for any given option.

For example, on Thursday the value of the January $38 put doubled to 65 cents, which represents its intrinsic value, and now has a delta of 1.0. This compares with the February $38 put, which gained 30 cents and now also has a value of $1.05 and a delta of 0.71. The June $38 put gained only 15 cents to $2.10 per contract and has a delta of just 0.53.

As this next question suggests, one thing that options delta will not reveal, and must always be considered in trying to gauge an option's expected price behavior, is implied volatility.

What does it mean when you see the short-term options trade down after earnings are good and underlying stock moves up, like today in Yahoo! ( YHOO) atthe money? Implied volatility? Market makers cleaning up?

--JG

As the reader says, I recently suggested that using short-term options to play earnings may not be the best choice for capturing an anticipated price move. His first assumption for the reason why short-dated options fail to respond to large price moves in the underlying stock is correct: What you are probably witnessing is a steep drop in implied volatility.

As for the market-makers, while they're often obstacles between you and profits, they are in the clear on this one. The market-makers not only don't control the supply and demand that drives implied volatility, but most likely did not reap any undue rewards.

It's good to be aware that steep drops in volatility, in which an option's price fails to move in accordance with a change in price of the underlying security, also can occur when there is significant time remaining in the option.

Good examples of this occur in situations involving drug approvals or pending court decisions. Options with weeks or even months until expiration can see their implied volatility -- and therefore their value -- get pumped up ahead of the price-moving event, then quickly dissipate once the news is out. So before you buy an option, it's good to check its historical and current implied volatility levels to understand the size of the move necessary in the underlying security to turn a profit. Make sure you won't be fighting a headwind.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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