The Right Way to Trade Weekly Options
12/05/2011 12:45 pm EST
Options educator Jim Bittman describes several scenarios where weekly options are ideal trading vehicles, including how to use them as "insurance" against short, sharp market declines.
Taking a look at weekly options with Jim Bittman. Jim, have weekly options been around for a while?
Well, Karen, there’s a lot of history to weekly options. The Chicago Board Options Exchange (CBOE) filed for them in 2004 and got them approved in 2005. Weekly options on the S&P 500 index have been traded since the summer of 2005.
It was only in the summer of 2010 that several other exchanges started to list them on popular equities such as Google (GOOG), IBM (IBM), Research in Motion (RIMM), NetFlix (NFLX), that kind of thing. They exploded in the summer of 2010.
What’s the popularity behind them? Why did they explode?
Well, you know there are a lot of people, a lot of active traders, who like action. You can buy a one-week option for a very small amount of money, maybe 2% out of the market, away from the current underlying, and if you get the earnings announcement right and the stock moves 5%, 8%, or 10%, then you’re looking at a doubling, tripling, or more of an option.
See related: How to Play Earnings with Weekly Options
Is there any other advantage to the fact that you can take advantage of the short-term move quickly?
You know, it’s an interesting question, because there’s actually a portfolio insurance technique using weekly options which can be much less expensive than traditional portfolio insurance.
How do you mean?
Well, the typical person would like to buy a six-month put option that is 5% out of the money. That might cost you 5% or 6% of a portfolio’s value. That would protect you if the market declined more than 5% from today’s market level.
But suppose the market goes up 10% in the next three months and then falls 15%. Well, that’s right back to where your current protection is, and that option would give you no protection.
A weekly option, if you buy a new weekly option every week, let’s say only 2% out of the money, then you will always have one week of protection that’s 2% out of the money.
So, in my scenario, if the market goes up 10% and then collapses 15%, you have protection that’s up 13%. It gets you the last 13% down move. I know there’s a lot of numbers here, but the interesting point is that for short, sharp down moves, the weekly option is there to protect you.
And you just roll it over? Is it expensive though?
Well, that’s what a lot of people don’t understand. Actually, an out-of-the-money option, 2% to 3% out of the money (very, very short-term options), if you add up the price, they are actually less expensive than if you buy one six-month option that’s the same distance out of the money. It has to do with the nature of option time decay.
See related: Understanding Time Decay in Options
So you can get the same type of protection for less money?
Well, it is slightly different protection because it only exists for nine calendar days, but if we had a flash crash, if we had a 6% or 7% down move in one week—which has happened a number of times in market history— if you were to have that short move, then the weekly option would give you the protection you needed.
However, if you had a gradual three-month market decline for 15%, then obviously the weekly is not going to offer you as much protection because every week you’re going to be buying something that’s 2% out of the money.
So, you have to know your market, no doubt about it.
You need a specific forecast for protection with weeklies, and you need a different forecast if you’re going to use the longer-term options to protect your portfolio.