For investors interested in getting started with options, the number of, well, options can seem intimidating. Along with the strike price, the expiration date is a key component of any option position. In this segment from Motley Fool Live that first aired May 7, Motley Fool Canada analyst Jim Gillies and Fool.com editor/analyst Ellen Bowman discuss the right way to choose your expiration.
Jim Gillies: So with Apple (NASDAQ:AAPL). Apple’s currently trading for about 130 bucks. So if I wanted to set up a covered call on Apple, I might say sell what we generally want to do it in about three months increments.
Ellen Bowman: Tell me why that is, because you can choose options that go out forever, right? Well, two years I think is the max but.
Gillies: Two years is the max, but also you can go next week.
Bowman: Yeah, you can day trade with these things. Don’t do that, but you could [LAUGHTER]. You’ll never going to pay back.
Gillies: No, that’s exactly right. Don’t do that. I mean, you can.
Bowman: But don’t.
Gillies: You’re going to enjoy your tax time, by the way … Three months because it’s kind of the happy medium between. I’m going to trade less frequently. I mean, if I’m doing this every three months, I’m doing it four times a year. So my commission costs are going to be down. Options are not free to trade. I mean, it’s not like stocks here and that can add.
Gillies: That can add up, frankly. The other thing is, the further out you go, you are going to get paid more the more you go out. For example, I will go with the 140 strike price, assuming my computer decides to cooperate with me here. You can actually, Ellen, you can get paid $ 140 call option that expires today on Apple, you could buy it. It’s going to cost you about 19 cents.
Jim Gillies: If you want to go out a month, you want to go out to June 8th. Sorry, it doesn’t expire today, it expires next week, sorry. Anyway, brain cramp. But the June 140, our call, you’ll get paid about $ 1.20. The July, so two months out, you’re getting paid about 2.30. August, you’re going to get paid about 3.90. You can see you get paid more as you go out.
Gillies: But if you then start doing it on a per-month basis, remember one month out, you’re getting paid about 1.20. In two months out, you’re getting paid about 2.30. That incremental month, 2.30 minus about 1.20, it’s 1.10, so you’re getting less for that second month. Then the third month out, it’s 3.90 minus [OVERLAPPING] which is actually an oddball there. I’m not sure. That’s a bit of a pricing screw-up there. [LAUGHTER] I like that.
Bowman: You can take advantage of that maybe.
Gillies: I was going to say if I hadn’t locked myself out of that [NOISE] It’s usually the happy medium between amount of cash flow you bring in and minimizing commissions.
Bowman: there is a member who had a question about three months seems like a long time to leave yourself open. We might want to talk a little bit more about timing, and how you hit that middle point between you’re getting paid enough to make it worthwhile, but you’re not waiting so long then anything could happen.
Gillies: I can hit that one real easy.
Bowman: Okay, Let’s do it. Mr. Owen Frost, let us address your question.
Gillies: Okay. Why three-months?
Bowman: Yeah, exactly. He says it seems like a long period to leave yourself open to price movement of the underlying. You could use 1-2 months and take advantage of the rapid price decay on the call written. These three months seem to be the sweet spot. He’s looked at one month and is wondering does he need to reconsider.
Gillies: It can be, but again, the 145 strike here, one month, it’s 50 about 60 cents here. One month is 60 cents, two months is about 35, three months is 270. You want to make it worth your while. If the stock does rocket, you at least got a reasonable amount of income. Again, there’s the commission cost as well because you might have to be playing with this a little bit as well going forward. But you also want, like I said, to make it worth your while, and then the three-month thing also neatly lines up with how frequently a company reports its own earnings.
Bowman: This is true.
Gillies: You can’t avoid catalyzing dates. This is just a thing. I guarantee you no matter how long you might pick one month, you might pick one week, you might pick a year, at some point the company will release what we call material news.
Gillies: That will move the stock meaningfully up or down.
Bowman: The new Apple satellite or Tim Cook gets led out in handcuffs or whatever the news might be.
Gillies: Boy, that would be an interesting day [LAUGHTER].
Bowman: Let’s do them both together. Why not?
Gillies: I feel this is an appeal to authority fallacy, and I apologize in advance. I’ve gotten there by the happy medium of I like to get paid. I like a minimum of catalyzing dates. I want to make it worth my while. I’m typically not, in this case, if I was doing a covered call on Apple, I might not go to 145, I might probably be closer to 135. But again, it’s your choice as an investor. It really is your choice. But I just felt that as I’ve done this for two decades now, it’s the one that’s worked for me the best where it actually ends up leading to less follow-on actions.
Bowman: Yeah. Less maintenance, more profit.
Jim Gillies: Also, trust me, three months will go by super-fast.
Ellen Bowman: It does. I have a kid as do you, and that’s no time.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.