Have you ever felt confused when looking at options chains? To get to the option order placement page, an investor needs to choose one contract among many expirations and available strikes. How can you narrow the search and decide on a particular expiration and strike?

Learning how the two choices affect your risk profile can help you select options that align with your trading strategies. We'll focus on single-leg strategies from a buyer's side to keep things simple.

Start with Your Outlook

The expiration date refers to the calendar date and time at which the options contract stops trading (i.e., "expires"). The options contract is either exercised or becomes worthless at the expiration date. Either way, it cannot be held past this date.

Let's say you are bullish on ABC stock, so you bought an ABC Call. Let's check the breakeven of three hypothetical options.

The more time until expiration, the more expensive the options are—but why? Suppose the ABC stock price remains below $100 until the February expiration date. In that case, the February call will expire worthless, but the other two longer-term call options still have a chance to turn profitable, and as such they still have time value. So, the tradeoff when buying longer-term options is that they come with a higher premium and, consequently, a higher breakeven price.

How do you decide which expiration date is suitable for your strategy? Well, that depends on your personal market attitude. How far out you choose to buy an options contract depends on how long you think it would take for your trade to become profitable. Start with your outlook. Then you can determine which specific option is most appropriate.

Always Watch out for Time Decay

Options are depreciating assets. Their time value decays as it approaches expiration, This change is called “time decay” and it is usually expressed with the Greek letter Theta. As shown in the chart below, time value decay is not linear. With everything else held constant, the time value erodes faster (that is, Theta increases) as an option gets closer to expiration.

A three-month option will undergo less time decay per day than a three-week option with the same starting value. It is important to keep this chart in mind, as time decay plays a big role in deciding which expiration dates are best suited for your strategy.

When buying an option, many investors tend to buy shorter-term options because they are cheaper. Intuitively, it makes sense to buy an affordable option, but actually, they are just as risky. Even though short-term options can provide a huge potential upside return on capital for the powerful leverage effect, they can also go to zero very quickly if the stock moves in the wrong direction or doesn't increase enough in value (for a call option) to counteract the time decay effect. They are usually cheaper because of the short time horizon, but that also means that theta decay is strong, and the options lose value even quicker.

If you expect an event, such as earning call or company conference, that can drastically move the stock price in the near term, playing short-term options may be a good choice. In practice, there is an alternative method for investing based on short-term expectations. You can buy a longer-dated option and hold the position for the same amount of time as a shorter-dated option and experience a smaller amount of time decay.

Which Strike: Check the Risk/Reward Tradeoffs

An option's strike price is the price at which the underlying asset will be bought or sold if the option is exercised. The relationship between the strike price and the market price of the underlying asset tells us whether an option is in-the-money (ITM) or out-of-the-money (OTM). See the chart below for more on this. When the stock is the same as a strike, it is called at-the-money (ATM). Since the stock price moves up and down all the time, an ATM option cannot keep that status for long.

When the stock price moves farther away from the strike price, the option is getting deeper ITM or OTM.

• The deeper ITM an option goes, the higher the likelihood of the option finishing in the money, or being exercised. The tradeoff is that you need to pay a higher premium to buy the contract.

• Conversely, the deeper OTM an option becomes, the higher the possibility of the option expiring worthless, and as such, the lower the cost the contract trades at. Even though they are cheaper, buyers of OTM options accept a higher probability of losing the full premium paid if the option is held to expiration.

Let's say ABC is now trading at $101, and February ABC 100 call is only slightly ITM. Whether the February ABC 100 call will expire ITM or OTM is highly uncertain, for a little movement in price, dipping $2, can change the slightly ITM call into OTM. In contrast, with less uncertainty, a February ABC 80 call is more likely to remain in-the-money until the expiration date.

When deciding which option to buy, how do you know if a $100 or $80 strike price is best for your strategy? There might be options with strike prices of 85, 90, 95, 105, 110, 115, 120, and more. In practice, strike selection depends mainly on your preference for risk-reward tradeoffs.

Suppose you're only willing to risk a modest amount of capital on your call trade. The OTM call may be your best choice, and it can generate a more significant percentage gain if the stock spikes above the strike price, driving your call option ITM. But it has a much lower probability of success. That means that even if you invest less capital to purchase an OTM call, the likelihood of losing the entire amount of your investment is more significant than with an ITM call.

Summary

Picking the right expiration date and strike price is not easy. After considering your outlook, time frame, and risk tolerance, you should know which choice will be right for you. Remember: there is no perfect option contract.

When you try different strikes and expirations on Webull Paper Trading, you can gain a first-hand understanding. Let's get started>>>