Options have a defined life and option traders select the duration that matches their forecast. Most stock and cash settled index options expire on the third Friday of every month. The expiration months are categorized as, front month, back month and LEAPS. Options that expire in less than four weeks (five weeks in a five week cycle) are considered front month options. Options that have more than four weeks of life are considered back month options. Options that have six or more months of life are called LEAPS. The more time an option has, the greater the time premium. Intuitively, a stock option with a great amount of time has a higher probability of being profitable. A $45 stock has a greater probability of moving above $50 in a three month period of time than it does in a three-week period of time. Option traders that believe a stock is poised for a quick explosive move should trade front month options. They will be cheaper and the trader can buy more options. Time premium decay is a factor and the move must take place quickly in order for the trade to work out. Option sellers like to sell front month options because of accelerated time decay in the last few weeks of life. An option trader who believes the stock will continue a long-term trend might consider buying a back-month option. An investor looking for a leveraged stock position might consider buying a LEAP call instead of the stock.
November 11, 20082 min read