As most of you know, I mostly deal with high-probability options-selling strategies. So, the benefit of having a new and growing market of speculators is that we have the ability to take the other side of their trade.
I like to use the casino analogy. The speculators (buyers of options) are the gamblers and we (sellers of options) are the casino. And as we all know, over the long term, the casino always wins.
Why? Because probabilities are overwhelmingly on our side.
So far, my statistical approach to weekly options has worked well. I introduced a new portfolio (we currently have five) for Options Advantage subscribers in February 2014.
We’ve made 43 out of 51 successful trades in the Weekly Options Portfolio for an 84.3% win ratio. The 51 trades have come over a period of several years, so we are averaging almost 1.5 trades per month in the portfolio.
The key is to point out that while these are weekly trades, we are using a strict set of guidelines to place our weekly trades. We are not going out and just making random weekly trades for the sake of trading action. Taking the more-is-better approach is not sustainable. I only care about taking action on the highest probability of trades – the ones with the true odds. This is why you only see an average of 1.5 trades per month in the portfolio.
So how do I use weekly options?
I start out by defining my basket of stocks. Fortunately, the search doesn’t take too long, considering weeklys are limited to the more highly liquid products like the SPDR S&P 500 ETF (NYSEArca: SPY), PowerShares QQQ Trust (NASDAQ: QQQ), SPDR Dow Jones Industrial Average ETF (NYSEArca: DIA), iShares Russell 2000 ETF (NYSEArca: IWM) and the like.
My preference is to use the S&P 500 ETF, SPY. It’s a highly liquid product and I’m completely comfortable with the risk/return it offers. More importantly, I’m not exposed to volatility caused by unforeseen news events that can be detrimental to an individual stock’s price, and in turn, my options position.
Once I’ve decided on the underlying issue, in my case SPY, I start to take the same steps I use when selling monthly options.
I monitor on a daily basis the overbought/oversold reading of SPY using a simple indicator known as relative strength index (RSI). And I use it over various time frames (2), (3) and (5). This gives me a more accurate picture as to just how overbought or oversold SPY is during the short term.
Simply stated, RSI measures how overbought or oversold a stock or ETF is on a daily basis. A reading above 80 means the asset is overbought; below 20 means the asset is oversold.
Again, I watch RSI on a daily basis and patiently wait for SPY to move into an extreme overbought/oversold state. Once an extreme reading hits, I make a trade.
Again, it must be pointed out that just because the options I use are called “weeklys” doesn’t mean I trade them on a weekly basis. Just like my other high-probability strategies, I will only make trades that make sense.
As always, I allow trades to come to me and never force a trade just for the sake of action. I know this may sound obvious, but other services offer trades because they promise a specific number of trades on a weekly or monthly basis. This doesn’t make sense, nor is it a sustainable – and more importantly, profitable – approach.
OK, so let’s say SPY pushes into an overbought state, like it did during the latter part of last week.
Once we see a confirmation that an extreme reading has occurred, we want to fade the current short-term trend, because history tells us that when a short-term extreme hits, a short-term reprieve is right around the corner.
In our case, we would use a bear call spread, also known as selling a vertical call spread. A bear call spread works best when the market moves lower, but it also works in a flat to slightly higher market.
And this is where the casino analogy really comes into play.
Remember, most of the traders using weeklys are speculators aiming for the fences. They want to take a small investment and make exponential returns. Not us. Why? Because we want the odds stacked on our side.
Take a look at the options chain below.
Knowing that SPY is currently trading for roughly $247, I can sell options with a probability of success of almost 80% and bring in a return of 23.3%.
Just look at the 251 strike. If we sell the August 21 strike (weekly) and buy the August 253 (weekly) we can bring in $0.36 ($0.66 – $0.30) for again, a 23.3% return.
In most cases, I look to take the trade off early . . . preferably when I can lock in at least 50% of the premium sold. For this trade I want to make at least $0.20, or 11.1%.
So far, so good.
Since the inception of the Weekly Options Portfolio the average duration of a trade has been 12.8 days. The win ratio has been 84.3% with an average return per trade of 3.1%. But a 3.1% return per trade over the course of 51 trades adds up. Maybe not overnight, but that’s not the goal. The goal is to generate steady, consistent income on a short-term basis . . . and so far, the strategy has proven effective over the past 42 months.
If you are interested in learning the intricacies of my step-by-step approach when trading weekly options please sign up for my free webinar. You’ll not only learn how I trade weekly options, you will also learn a few other simple options strategies that use probabilities to your advantage.
If you can’t make it, no big deal. Register today and I will make sure you receive the recorded presentation shortly after the live event to watch at your leisure.