Anyone watching tastytrade will eventually realize that we use 45 days to expiration (DTE) in almost all our studies. Our research has shown that is the best choice. Still we receive many emails questioning the 45 day “rule." Tom Preston aka TP, joins the guys to explain why the 45 DTE figure is the inflection point in option models.
We are currently experiencing a low Implied Volatility (IV) environment. We like to sell option premium in high IV and high IVR environments but we also believe in staying engaged in the market. Some have asked if we should go out in time to collect more premium. TP points out that if you are choosing strategies based upon probability of profit (POP) then the answer is no. The 45 day area is an inflection point where the increase in premium for an option with a given probability of profit slows dramatically. TP proves this is true using a series of graphs and slides. Although the price of the option increases the further out you go, the steepness or percentage increase rapidly drops off at 45 DTE.
What really would convince any doubters is when TP revealed why the 45 day area is an inflection point. He displayed a formula and then explained that increasing time has the same impact on the normal distribution curve as increasing volatility. The increase in time widens the normal distribution and pushes the 1 Standard Deviation strike further out-of-the-money (OTM). TP further explained how the non-linear impact of time on the normal distribution, probability model, and option pricing creates points where the rates of change of the option premium is lower than the additional risk you take with the extra days. When you go further out in time, increasing the DTE, each day you add results in a smaller increase as 1/45 is larger than 1/46 which is larger than 1/47 etc, while the distribution widens.
For more on Days To Expiration choices see:
Market Measures from May 1st, 2015: “Days to Expiration | Time Frames”
Market Measures from November 10th, 2015: “Extending Duration in Low IV”
Market Measures from December 10th, 2015: “Comparison | 30 DTE and 60 DTE”
Market Measures from January 11th, 2016: ‘Short-Term and Long-Term Fear”
Market Measures from May 6th, 2016: “Decay Comparison | 30-Day Holding Period”
Watch this fascinating segment of The Skinny On Option Modeling with Tom Sosnoff, Tony Battista and Tom Preston (TP) for a better understanding of why 45 DTE really is the magic number for selling option premium.
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