Weekly options have become more and more popular in recent years. In efforts to provide further means of obtaining desired exposure and additional means of hedging exposure, exchanges have added weekly option listing to many products including certain stocks, indices and futures contracts.
While these weekly options may potentially provide profit opportunities, they may also provide a great way to get your ass handed to you fast…
Weekly options are often discussed in option writing circles due to their limited timeframe of exposure and rapid decay rates. While these are both potentially positives for those looking to collect premiums, these options often carry low corresponding premiums and high gamma risk.
Stock ABC is currently trading at $80 per share and is often quite volatile. A put option that expires at the end of the first week of the month and has a strike price of $75 is trading at a premium of $.25. While once could potentially sell that option and keep the $.25 in premium if the stock stays above $75 at expiration, what happens if the stock makes a large and sudden move lower?
The value of that put option could potentially increase many times over producing significant losses. One may be forced to close the option at a loss or may have to take delivery of the shares at the strike price of $75. If the stock were to fall to $65, for example, one cold be looking at losses of nearly $10 per share. Not a very good deal is it?
Like any other type of trading, one must always consider risk versus reward…
Trading is all about risk management. If you are looking at selling weekly options to try to generate income, you must understand the risks involved. Naked option selling can produce losses over and above your initial investment. Such trading is certainly not suitable for all investors. There are ways, however, to quantify these risks. One can look to sell credit spreads, for example, to manage position risk.
Covered Call Writing
Covered call writing can be a way for investors to potentially boost returns while also mitigating risk. Calls can be written against long positions in stocks or other instruments. When looking for stocks to write covered calls against, there are some things you may want to look for in order to try to make the most of this strategy.
Some of the things you may want to look for in a stock include:
•• Sideways price behavior
•• Slight uptrend
•• Pays a dividend
•• Exhibits some degree of volatility
Let’s look at an example:
You own 100 shares of stock ABC. You purchased 100 shares at an average price of $32 per share. The stock is currently trading at $35 per share and has been in a range from $32 to $36 per share for the last year.
Now that the price is reaching the top end of its trading range, you can consider writing a call against your long shares. You do not expect the stock to trade above $37 per share, and therefore elect to sell a front month $37 call option for a premium of $.40.
One of three things may now happen:
1. The option expires worthless and you keep the premium collected
2. The stock rises and you elect to buy the option back
3. The stock rises above the short call strike price and your shares are called away
The beauty of the strategy is that it puts the unstoppable power of time to work for you rather than against you. The stock can go up, down or sideways and the option may still be losing value. Of course, if you are wrong and the stock price rises too far; you will have to decide whether to close the short call at a potential loss or risk having your shares called away.
The Long Straddle
What is a position you can use to try to capitalize on a big market move when you don’t know what direction that move will take? One position that may potentially suit your needs is the long straddle…
The long straddle gives you:
•• The potential to profit regardless of market direction
•• The potential to profit from an increase in implied volatility
••Of course, you can also lose money trading straddles.
•• A long straddle is the purchase of both an at-the-money call and at-the-money put of the same strike and expiration.
•• A long straddle may potentially be most effective when you are looking for a very significant directional move and when implied volatility is relatively low.
•• You are looking for the extent of the move to exceed the total premium paid for the options and/or for a large increase in implied volatility…
Stock ABC is trading at $50 per share and has an earnings announcement due to be released. You think that the stock may make a huge move but do not know in which direction. You decide to purchase a front month straddle by purchasing the $50 call for $5 and the $50 put for $5.
The total premium paid is $10, therefore, you will need the stock price to move plus or minus $10 in order to make a profit at expiration. Anything less than a $10 move will cause losses dollar for dollar up to $10. A full $10 loss of premium paid could occur if the stock price stays right at $50 at expiration and both options expire worthless.
In addition, time decay will eat away at a straddle rapidly and must be accounted for when considering such a position.
The Butterfly Spread
The butterfly spread is a versatile yet often misunderstood options spread. The butterfly spread gets its name from its wings and the size of the spread’s wings can be adjusted according to trade objectives and risk tolerance.
A simple way to look at a long butterfly spread using call options is the simultaneous purchase and sale of a call spread.
You believe shares of ABC are likely to rise from their current level of $20 per share. You also believe, however, that the shares will not likely go any higher than $22 per share. Volatility has also been on the high side recently and you therefore elect to initiate a butterfly spread using calls.
You purchase the at-the-money $20 call option, sell two of the $22 call options and purchase one of the $24 call options. What have you effectively done? You have purchased the $20/$22 call spread and sold the $22/$24 call spread…
Since you believe the stock price may rise, but only to a degree, you sell the $22/$24 call spread to help finance the purchase of the $20/$22 call spread. This type of spread is put on at a net debit, and that net debit represents the maximum exposure on the trade.
Maximum profit is reached if the stock price is right at the middle strike, or body of the butterfly, at expiration. In this case, the long call spread reaches full intrinsic value while the short call spread expires worthless.