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If you're hedging with a back month / leap option, what are good underlying / market conditions to move this option out even further in time?

For simplicity, let's say you own a call with 6 months expiration. What conditions provide the best "prices", for selling this option, and then buying another further out in time, perhaps 9 months or 1 year out?

I realize this might take different forms based on what the underlying is doing relative to the option, but perhaps those could be addressed as cases.

--------------- Added after CQM'S answer, an additional clarifying question -------------

Does a leap with 6 months expiration, and then a leap with 1 year expiration (same strike), generally follow a ratio, regardless of implied volatility? So, say the 6 month leap was \$5, and the 12 month leap was $8, at a given market volatility level, this would make a ratio of 8/5, the cost of the 12 month leap over the 6 month leap.

If the volatility of the equity & market subsequently changed, perhaps became quite a bit lower, would this ratio likely still be 8 / 5 between the 12 month leap and the 6 month leap?

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1 Answer

up vote 3 down vote accepted

with leaps you have to consider market volatility and the equities volatility. market volatility increases the price of all options and is (merely) correlated with big market corrections. equity volatility can be due to a variety of factors, but with leaps it is after a big drop in that equity due to unfavorable news.

leaps can get tricky due to their inverted pricing (due to volatility, stock drops, call increases in value, stock rises after volatility was high then call deflates in value before gaining intrinsic value back)* *depends on gamma and delta of course too

when your leap has inflated volatility, less than 6 months left, that is a good time to roll

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Thanks. Can you expand on the last part, why rolling on inflated volatility is good? Obviously one will gain more on the sale, but won't one pay more for the purchase? E.g. Let's say I can sell the nearer term leap for \$5, but have to buy the longer term leap for \$8, paying \$3 more. If market & equity volatility were low, and the nearer term leap was perhaps \$3.50, would the longer term leap likely be more than \$6.50 (\$3.50 + \$3.0), or less? ... I'm going to expand my question so that it's clearer with this. –  Ray Nov 26 '11 at 16:52
    
the effect of volatility decreases the further out you go (because nobody expects market conditions to be the exact same 6,12,24 months from now). the more time you have, the less important the entry is. so on your front month leap, theta decay is accelerating and you can expect volatility to deflate the price as well. you are aiming for a new debit in this spread, so the back month should be expensive solely due to theta –  CQM Nov 26 '11 at 18:33
    
Thanks. What is it that is the primary determiner of a price then in long term options? It makes sense what you're saying ... people don't expect the volatility to remain the same, but what then is driving that 1 year leap option price (say at the money)? Thanks. –  Ray Nov 26 '11 at 18:58
    
theta theta theta theta theta! theta is synonymous with time value. You have to think of options as insurance, you pay more for longer coverage, and when people think the coverage is worthless (like... 1 day before expiration and out of the money) then the option is near worthless. theta gradually decreases throughout the lifespan of the option. with LEAPS, there is a lot of theta no matter how much intrinsic value is there. –  CQM Nov 26 '11 at 19:29
    
I see, so are you saying, since most of the time theta is the determining factor, that when volatility spikes up highly, its effect in the price is greater. At this time, the ratio (added to the bottom of the question above), is better for rolling out further in time? –  Ray Nov 26 '11 at 21:03
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