"Expiration" is a term that you will not hear a stock trader utter…why? Because when you own shares of stock, that ownership never expires (unless you choose to sell your shares of stock).
So why do options expire?
Unlike purchasing shares of stock, purchasing an option contract is generally used as a shorter-mid term investment. When you buy or sell an option contract (controlling 100 shares of stock), you must agree to an expiration date, as part of that contract.
As the buyer or seller of an option, you can choose which expiration cycle you would like to invest in. For most stock options, there are typically quarterly cycles, monthly cycles, and weekly cycles.
It is not vital to learn why expiration cycles occur in the weeks/months that they do (although we will touch on this a little bit in this post), but rather what is more important is understanding what expiration is and how to choose an expiration date because it becomes pivotal in determining whether or not a trade was a success or failure.
What Is An Expiration Cycle? A Brief History
Expiration cycles can be kind of confusing, so I'm going to do my best to break it down. 1973 is the year that the Chicago Board Options Exchange (CBOE) first started to allow equity trading. When they began, it was decided that when options are traded, there would be a total of four different months that each individual equity option could be traded during, each on a different cycle.
The typical increments for these options were 3 months, 6 months, 9 months, and 1 year. Typical cycles for an option would look something like this:
- January expiration, April expiration, July expiration, October expiration
- February expiration, May expiration, August expiration, November expiration
- March expiration, June expiration, September expiration, December expiration
Expiration Cycles Change - More Cycles!
Options gained popularity through the 70s and 80s as a way for investors to hedge their stock positions in the shorter term. As a result of this, in 1990 the CBOE made a change to the rules so that every stock option would have an expiration cycle in the nearest two months.
From then on, all equity options would have what was deemed a ‘front month’ (the closest month - generally the current month) and a 'back month' (the month proceeding the front month), which made the expiration cycles only slightly more complex.
Another development to expiration cycles spawning from the rising popularity of options in the 90s was the birth of a new type security, called LEAPS.
Long Term Equity Anticipation Security - Even More Cycles!
Long Term Equity Anticipation Security (LEAPS) were introduced as a way to make longer-term investments in stock options (things like indices did not have LEAPS until more recently).
So how long can an option contract actually be with LEAPS?
A LEAPS can expire up to 3 years from the current expiration cycle date, making the option as an instrument, a viable longer-term trading strategy for investors (I use 'longer' loosely because its very subjective and based on an investor’s trading style - i.e. for a day trader, 3 years would be an eternity, but for a buy and hold style trader, it's short-term). LEAPS added on additional expiration cycles to underlyings, extending the investing calendar from 1 to 3 years.
Where does that leave us?
After LEAPS were introduced, expiration cycles got quite a bit more complex. Like previously mentioned, it’s not necessary for you to understand the ins and outs of why expiration cycles occur at the frequency/times they occur at. With trading softwares, it’s no longer necessary to memorize or understand why certain underlyings have certain expiration cycles and other don’t. What’s most important is understanding what expiration cycle choices you have to make.
If you do want to know more about how the cycles currently work after to the addition of front month/back month and LEAPs cycles, investopedia does a great job breaking it down here.
Why Is Options Expiration So Important?
In the most basic sense, expiration is important because it sets a timeframe for your trade. Whether or not a trade is going in the right direction and how much time left until that option expires define what profit or loss you will incur as an investor.
How many days you have left until an option expires is called days to expiration (DTE). During the time between the placement of the trade and the expiration date, a variable called theta (time decay), will determine if your trade is profitable or not. As the amount of time until your option expires - theta decay - decreases, this is favorable to the seller of the option, and not the buyer.
One fear that keeps some traders from placing their first options trade is the fear of being assigned stock (especially if you have a smaller account with funds less than that of what 100 shares of a stock would cost). Don’t let this fear stop you from placing your first options trade. It’s not that scary, I promise!
If you sell an option (naked or as part of another strategy - i.e. Iron condor) and that option is in the money when the option expires, you will be assigned stock. If you buy an option, you will never automatically be assigned stock. As the buyer, you always have the right, but not the obligation, to purchase the stock via the option you invested in.
How To Choose An Expiration Date
Choosing an expiration can be difficult, so here are some things to keep in mind when choosing an expiration date.
When picking an expiration date, your trading style should guide what expiration you choose. For example, if you day trade, you will probably always use the nearest expiration cycle. A premium seller may want to go farther out and find an expiration cycles with about 25-50 days to expiration, while someone who does technical analysis may adjust their DTE according to what their charts are telling them (which can vary from underlying to underlying).
Are you a premium seller (someone who sells options to collect premium)? tastytrade has done a ton of research into the mechanics of selling premium. After countless studies, the research team has found that you stand the best chance of profiting when you sell options with 25-50 days to expiration.
As mentioned before, most stock options have weekly, monthly, and quarterly cycles. Something to keep in mind when choosing an expiration date is what cycle the option is in, as this can have an impact on how liquid the underlying is. Weekly cycles tend to be less liquid than monthly/quarterly, so you may have a little trouble getting out of a trade in a weekly expiration cycle. Always keep liquidity in mind when choosing an expiration.
That may leave you wondering: why would you choose to invest in the weekly expirations if those options are generally more illiquid than monthly expirations?
There are several answers to that question, but the most popular are that weekly expirations would fit better in your strategy (if you invest in options that are between 1-10 trading DTE, then weekly expirations would provide you more opportunities to invest) and weekly expiration cycles are commonly used for earnings trades.
Earnings are another important consideration when determining an expiration date (along with dividends for similar reason). Earnings are a binary event, meaning that one of two outcomes can occur...the price can go up or down after earnings are announced and many times, earnings cause large swings in an underlying's price and there is a corresponding 'crush' in the options volatility.
If you put a position on and there are earnings before that position expires, beware of the possibility of the changes in price caused by the earnings announcement. The amount that an underlying may go up/down after an earnings announcement is called the expected move. What the expected move does is quantify the potential move using statistics and historical data, ultimately giving you a price range that the underlying is expected to stay between.
Understanding Expirations On tastyworks' Trade Page
Understanding the concept of expiration is one thing, knowing how to decipher it within a trading platform can be a whole new ballgame (due to shorthand terminology).
Anytime you set up a trade on tastyworks, you will need to pick an expiration cycle. One of easiest ways to do this is using the expiration buttons on the trade page pictured below.
You'll notice that the expiration is written on the individual option and in the order section. We can also choose expirations and set up trades on the table trade page.
You will see the expiration listed as"Apr 21 30d", but what does that mean exactly?
"Apr" - April (the month will always be located first)
"21" - 21st (the date of expiration in the given month)
30d - 30 DTE (days until the option expires)
Choosing the date of expiration for an option can definitely be a difficult task for a newer trader. When starting out, keep in mind the aforementioned factors that can help you choose an expiration date to improve your chances of success:
- Your trading style
- Upcoming earnings/dividends
- Liquidity (weekly v. monthly v. quarterly expiration cycles)
The last most important aspect to this whole post? Figure out what is working for you! You can do this on the tastyworks platform by looking at the History page.
By analyzing your successful trades, you can begin to see what aspects of your mechanics have been working the best. Check out the DTE for your winning trades and see which range you found the most success in (and do the opposite to see which ones did the worst, then you can figure out what range did not work you).
(Watch Step Up to Options to learn more about different types of option trades)
IF YOU HAVE ANY ADDITIONAL QUESTIONS ABOUT EXPIRATION, LEAVE THEM IN THE COMMENTS!