How to Trade SPY Options for Profit

12/07/2011 8:00 am EST

Focus: OPTIONS

Adam Warner

Author, Options Volatility Trading

Adam Warner, a regular contributor to Investorplace.com, discusses tips and tricks for making profitable option trades on the popular SPY ETF.

The availability of options to trade has expanded tremendously over the past few decades. Not too long ago, there was just one options expiration date per month, and it was always the third Friday.

For each stock, commodity, or underlying asset, we traded the first two monthly cycles, and had from two to four additional expiration cycles. Option strikes were $2.50 apart for stocks under $25, $5 apart for stocks up to $200, and $10 apart for stocks trading above $200.

Fast forward to 2011, and now you can trade options in basically any time frame (from a few days to even a few years), and with strikes often $1 apart, even in triple-digit names.

Take the S&P 500 SPDR (SPY) for example. It offers 16 separate expiration cycles to trade, from options expiring within a week to options expiring in January 2014. And they don’t just expire on third Fridays.

Some are weekly options, which expire every Friday. There are also quarterly options, which expire at the close of business on the last trading day of the month in March, June, September, and December. And of course, there are the standard monthly options, with which you may be most familiar.

Just take a quick look at this screenshot of SPY calls (click to enlarge). You’ll see there are three currently traded expirations just in December.

chart
Click to Enlarge

So with all the choices, how do you decide what to trade?

I’d say use the added flexibility to your advantage. Pick a time frame you’re comfortable with and roll with it.

Want to Trade Weekly Options? Here Are Some Things to Consider…

Weeklies are best suited for more active traders—at least those who can keep a close eye on their positions—mainly because there’s just no premium cushion to mitigate a bad position.

Let’s look at SPY, for example. The straddle (that’s when you buy to open a call and a put at the same strike price in the same expiration month, or you could instead sell to open both options) in the closest at-the-money strike in the December weeklies—$126—trades for about $3.

(At current prices, both the $126 call and its corresponding $126 put are trading for about $1.50, so you would pay $3 to purchase both, or collect $3 to sell both.)

That sounds great, right? I mean, let’s say you sell one contract, and you’re covered from $123 to $129. (That’s $126 +/- $3.)

One problem, though: we get 2% gaps just about every other day now. So if that happens at any time in the next four trading sessions (until these weeklies expire on Friday), you’re going to wake up and find that SPY has already pushed your profit potential to the brink.

You can buy it of course, but then you have risk the other way. Nothing happens, and you’re out close to the entire $3 in four trading sessions.

Either buying or selling the straddle could work spectacularly well, or could prove disastrous. The point is that it’s a risky bet either way, particularly if you aren’t able to check in on your trade.

See related: Key Benefits of Weekly Options

NEXT: Good Reasons to Choose Monthly Options

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Standard Monthly Contracts Are Always an “Option”

Regular December expiration expires a week later, on that familiar third Friday. There, that same straddle goes for about $5. You would have an extra week with that trade, with the later expiration date…hence the extra premium.

Its overwhelmingly likely SPY will move a bit away in one direction (and one side of the trade becomes in the money) between now and then, but the now out-of-the-money leg of the trade won’t immediately go to zero, so you have a bit more cushion to play with.

In other words, if SPY moves to $123, the $126 calls with a week-plus to go will still have some value, so the straddle will not explode or implode like the weekly does.

Even so, there’s still not an enormous amount of time remaining.

My Preferred Way to Play SPY Options Right Now

Personally, I like trading options in the five- to seven-week time frame, whether I’m a net buyer or seller. On the buying side, it gives me time for my thesis to play out (assuming I have some sort of thesis to begin with).

Right now, that brings me to regular January expiration, with just under seven weeks to go. The $126 straddle there goes for about $8.85 as I type. If I buy, it gives me some time to buy and sell SPY stock against it. If I sell, it’s not an overnight boom-or-bust bet.

Go much further in time and a lot has to happen to move the needle on a Delta-neutral options play (i.e., we’re playing with the at-the-money strikes and not establishing a directional trade). So to me, the five- to seven-week range provides the perfect sweet spot. But by all means, use the myriad time choices on the board to find what suits you best.

By Adam Warner, contributor, InvestorPlace.com

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