Do I use weekly options as part of my overall strategy?
It’s a question I’m often asked. Up until the last few years, it was a question I answered with a resounding “NO.”
“Weeklys,” as they are known in the options world, are not even a decade old. And like most new financial products, it took weeklys a while to grow in popularity. It wasn’t until the last five years that weekly options were a viable product.
But the landscape has changed.
The increase in the popularity of weeklys has made for highly efficient products that offer tight bid/ask spreads, a necessity for successful options traders. Without a tight bid/ask spread you often have to make 10%, 15% and upwards of 30% just to break even on a trade.
Who wants to need a 15% return, not including commissions, before a profit occurs? It doesn’t make sense. That is why I was so hesitant in the beginning. I wanted to see volume, followed by tight bid/ask spreads before delving into the world of weeklys. But as I said before, the landscape has changed.
Now we can trade hundreds of different highly liquid underlying stocks and ETFs. But that’s not the only change.
When weekly options were introduced, the products offering weeklys only used what is known as standard expirations, which had a lifespan of eight days. Now we have the ability to trade weeklys with expanded expirations going out as far as six or even eight weeks in some cases.
Expanded expirations offer options sellers, like myself, a more fine-tuned way to take advantage of the rapidly accelerating time decay that occurs during the final week of an options life.
How to Generate Income with Weekly Options
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 four) for Options Advantage subscribers in February 2014.
I must 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.
I want to focus on the percentages in the far left column.
Knowing that SPY is currently trading for roughly $218.86, I can sell options with a probability of success in excess of 85% and bring in a return of 13.6%. So if the underlying ETF, in this case, SPY stays our short strike of 222, we will make 13.6% return on the trade.
Just look at the September 222 strike. If we sell the 222 strike and buy the September 223 we can bring in $0.12 ($0.22 – $0.10) for again, a 13.6% return.
If I lower my probability of success I can bring in even more premium, thereby increasing my return. It truly depends on how much risk you are willing to take. I prefer 80% or above.
Take the September 221.5 strike. It has a probability of success (Prob.OTM) of 81.71%. If we sell the 221.5 strike and buy the September 222.5 we can bring in $0.16 ($0.31 – $0.15) for again, a 19.0% return. Those are still incredible odds when you consider that the speculator (the gambler) has less than an 18% chance of success.
It’s a simple concept that for some reason not many investors are aware of.
Another scenario would be to widen the spread to bring in more premium, while maintaining the same probability of success on the trade. Just know, widening the spread to allow for more premium comes with additional risk. Nothing is free in investing … nothing. There is always a trade-off. Let us look at an example.
Take our September 221.5 strike. Again, it has a probability of success (Prob.OTM) of 81.71%. If we sell the 221.5 strike and this time buy the September 223.5, thereby widening our spread from 1 to 2 strikes we can bring in $0.17 ($0.31 – $0.07) for a 13.6% return.
Our return is the same as the September 222/223, but the probability is actually greater with the one strike wide 222/223 spread over the two strike wide 221.5/223.5 spread. What makes more sense to you? These are the types of scenarios and trades that I will be going over next week in the webinar.
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.