Option Lesson in Real Life

Feb. 2, 2011 - PRLog -- One of the notes that I keep stuck to my computer reads “remember seasonality”. For those just now becoming familiar with options, you may assume I am reminding myself not to forget deer season or the opening of the season for striper fishing. While these are important dates for many of us to remember, I am reminding myself that there are distinct periods within the options expiration cycle where certain trades work better and give a competitive advantage to the trader who recognizes and takes advantage of this seasonal pattern.

As a quick review, remember that option cycles historically have been established with monthly expiration cycles. For the knowledgeable option trader, different time periods within this monthly cycle are known to have distinct characteristics. The primary reason for these different characteristics is the “non linear” decay of time premium.

This “non linear” behavior simply means that the decay of time premium accelerates as expiration approaches; for us visual thinkers, envision a snowball rolling downhill. The recent arrival of weekly options has opened a whole new concept of seasonality for traders using those vehicles, but that is a discussion for a future time.

The butterfly is one of the option constructions most affected by seasonality. The last two weeks of the monthly option cycle is even called “butterfly season” by many option traders. The classic behavior of butterflies is that they are only slightly impacted by changes in the price of the underlying early in the cycle and exhibit increasing response to price change late in the option cycle. This peculiar functional characteristic has frustrated many traders who have tried to employ butterflies early in the options cycle and have routinely seen the correctly predicted price action result in minimal or no profit in the position.

For those of you unfamiliar with this construction, let’s look at an example. First and foremost, we need to be aware of our position in the cycle. February options expire Friday, February18, this is 17 days from today. That is close enough to the mid point of the cycle to be open season for butterflies.

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