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By: Steve Sosnick Chief Strategist at Interactive Brokers

For those of you who still get actual newspapers, this story ran on the front page of the second section of the Wall Street Journal: Traders Pile Into Boom-or-Bust Options to Play Stock Market Volatility. (It was posted online late Tuesday.) The reporters noted the increasing popularity of short-dated options, noting that about half of all activity in the options market occurs in options expiring within a week or less.

I was fortunate to be among those asked to comment for the article, and the first quote they used was “speculators love them” [short-dated options]. I stand by the comment, but I want to use today’s piece to expound upon the thoughts I presented.

There are valid reasons why speculators have gravitated to short-dated options. For starters, the time premium is minimal, so they tend to trade at lower prices. But it is important to remember that a lower price doesn’t necessarily mean that the option is truly cheaper. The shorter-dated option may have a higher implied volatility. Sometimes that is for good reason – especially if an event like earnings is expected – but sometimes it could simply be a reflection of higher demand from traders.

Also, the reduced time premium hardly means that it can be ignored. Options decay over time; that decay is represented by the Greek letter “theta”. Of course, we would expect theta to represent a smaller component of an option’s price as each day passes, but the effect of the residual theta is magnified. Theta is non-linear and accelerates as we approach expiry. One of the first lessons I learned when trading options was that “time decay falls off a cliff in the last week.” If you’re buying options with a low theta, that doesn’t mean that you won’t find yourself fighting its effects anyway.

Those of you who are inclined to write options will recognize that this can present an opportunity – and many have. As speculators gravitated to short-term, out-of-the-money calls in 2020-21, pushing up the implied volatilities of those options, some of that demand was met by covered call writers. If you’re writing calls for income – thus attempting to profit from theta — you might find it more appealing to write weekly calls four times a month rather than writing one one-month call.

Timing is always crucially important when trading, especially so when trading short-dated options. The risk/reward calculus is magnified and accelerated. A well-timed short-dated call or put purchase can lead to quick profits, but also allows the option to expire worthless more. On the flip side, a seller can reap premium income faster and more frequently, but short-dated options expose a covered seller to a greater likelihood having the stock called away or put to them and/or raise the naked writer’s chance for an exponential loss.

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