Making Option Price Erosion Your Ally
The Nations NDX PutWrite Index closed at 987.58 on Friday, a gain of 17.0 percent for 2019.
The selection of the put to sell is critical for any PutWrite strategy. In the past we’ve discussed why the NDX PutWrite Index sells put options which are just out-of-the-money, meaning the strike price of the put option is just below the level of the Nasdaq-100 Index when the puts are executed. These are the put options we sell because they have the most time value. This time value erodes generating additional return or providing a partial buffer for losses.
But how does this time value erode? We’d also discussed the fact that shorter-dated options erode more quickly than longer-dated options. For example, the NDX PutWrite Index is short the 8250 strike put option expiring on December 20, 2019. That option closed at 53.30 on Friday so it has 17 days remaining to expiration. That’s 3.14 per day. Let’s compare that to the 8250 strike put expiring a year later, on December 18, 2020. That option closed at 555.00 on Friday and has 381 days to expiration. That is 1.46 per day.
The reasoning behind this math of option erosion is complicated but it is robust, meaning we can count on shorter-dated options eroding more quickly than longer-dated options, everything else remaining the same (the rare exceptions are those options which are very far from at-the-money and have very little time to expiration – all of the time value will already have come out of these options).
Let’s take a look at a chart of the sort of erosion we can expect from an option over time to better understand how erosion accelerates. This is a hypothetical example since it assumes the underlying doesn’t move during the life of the option.
You can see that price erosion is nearly linear until about 30 days prior to expiration at which point the erosion accelerates.
That’s why the NDX PutWrite sells options which have approximately 30 days to expiration but there are several NDX option strategies which can take advantage of this phenomenon (an NDX BuyWrite is a prime example and we discuss another below) and there are others which need to be aware of this phenomenon to prevent it from being a drag on returns (buying NDX call options for index replacement is an example).
This difference in option price erosion is one reason so many traders and investors like to buy option calendar spreads using NDX options. When buying a calendar spread the trader buys a longer-dated NDX option and reduces the cost of the trade by selling an NDX option with the same strike price and type (put or call) but which expires sooner. This puts the math of erosion to work. The trade is done in expectation that the Nasdaq-100 index will have relatively little movement before the first option expires. If that occurs our trader will be long the remaining option at a significant discount to where it is likely to be trading at the time.
Using option price erosion is another way to get NDX options working for you.
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Performance of an index is not illustrative of any particular investment. Index returns quoted represent past performance which is no guarantee of future results.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.