Until recently, I had a terrible habit of selling weekly options. I don’t just mean the options that happen to expire on days other than the third Friday of the month; I’m saying that I would sell calls and puts that were to expire in 5 days or fewer. The allure of quick, easy profits would get the best of me, week after week. After all, what could be more enticing than taking advantage of the steep cliff dive in the final days of the well-known theta decay curve?
I figured, if I’m going to (financially speaking) push the guy on the other end of the trade off of a cliff… might as well make it a really steep cliff, right? And that part of the curve on the far right end of the chart, representing the final days before option expiration, is about as steep as it gets. So there’s your reason not to buy very short-term options: sure, they’re cheap, but they’re cheap for a reason. The time value portion of short-term options deteriorates in value rapidly and disappears entirely upon expiration.
Figuring that if one side of the trade is a bad deal, the other side of the trade must therefore be a really good deal, I would blithely sell calls and puts for ten cents apiece. Looking back, it’s amazing that I didn’t get clobbered doing this. I attribute this to pure luck and a market that has slowly ground upwards since early 2016. I didn’t deserve to escape with my trading account intact, but somehow I did.
What I was doing was, in effect, picking up dimes in front of a steamroller. You see, just because the buy side of the trade is a bad deal, doesn’t necessarily mean that the sell side of the trade is a good deal. The fact is, given the massive gamma risk in the final days prior to option expiration, the sell side of the trade is a terrible deal in terms of risk-to-reward: the reward is measured in nickels and dimes, while the risk is measured in dollars.
If you sell a short-term option for a dime per share, and the trade sharply goes against you in the final days before expiration, you may have to buy back that same option for a dollar or more. The gamma of the option that you sold will probably increase, thereby magnifying the theta of that option and quickly expanding the price of the option; if the implied volatility also increases, this could inflate the option’s price even more. And, there likely won’t be sufficient time to manage the trade in a cost-effective way. What seemed like easy money could quickly become a nightmare.
So now, I’m committed to the practice of selling options with 30 to 60 days until expiration when volatility expands and prices get to extreme or unjustified levels. That way, I’m paid sufficient premium to take on the risks involved, and the risks are somewhat mitigated by the fact that I’ll probably have enough time to allow the trade to work itself out if it goes against me in the early stages. Then, by liquidating the trade (and hopefully taking profits) halfway until expiration or earlier, I’ll won’t have to deal with the gamma risks involved in near-expiration trade management.
Thanks to mentors and friends such as Seth Golden and David Lincoln, I’ve learned an essential lesson without having to learn it the hard way. Weekly options: don’t buy ’em, don’t sell ’em. Just leave ’em alone.