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Options, A More Flexible Way To Target Profits and Maximize Leverage

InvestorEducation / Options & Warrants Jan 19, 2011 - 06:55 AM GMT

By: Money_Morning

InvestorEducation

Best Financial Markets Analysis ArticleLarry D. Spears writes: Standard options have long offered a more flexible way to invest. But a relatively new product called Weekly Options, or "Weeklys," gives investors an even more efficient way to use leverage and target profits.

Weekly options have the same terms as standard options, except they expire every Friday instead of every third Friday.


In other words, you can now trade options on a select group of underlying assets that have expiration dates every week of the year. To be precise, they're first listed on Thursday of each week and expire at the close of trading on Friday of the following week (adjusted for holidays).

The Chicago Board Options Exchange (CBOE) actually introduced the first weekly options in late 2005 on the Standard & Poor's 500 Index and the S&P 100 Index, but the initial interest came primarily from professional traders and brokerages, with the average weekly volume running well below 5,000 contracts. [Note: To see a list of Weeklys currently trading on the CBOE that appears elsewhere in today's issue, click here.]

Interest slowly increased over the next couple of years as weekly options on other major indexes were added to the CBOE roster. But it wasn't until the fall of 2008 - with the financial markets in turmoil - that average weekly volume topped 10,000. Then in 2009, as several options were introduced on exchange-traded funds (ETFs) - including funds linked to gold, silver, oil and emerging-market stocks -traders had vehicles to effectively play short-term swings in those volatile markets.

Beginning in late 2009 and continuing through 2010, new weekly options were introduced on more than 20 of the most popular and actively traded individual stocks. That includes Apple Inc. (Nasdaq: AAPL), Amazon.com Inc. (Nasdaq: AMZN), Google Inc. (Nasdaq: GOOG), JPMorgan Chase & Co. (NYSE: JPM) and International Business Machines (NYSE: IBM).

Those additions sparked an explosion of interest among non-professionals - both active traders and more conservative investors - and the average weekly volume for the new weekly options skyrocketed above 300,000 contracts by November 2010.

Also helping the new options gain wider acceptance was an increasingly successful campaign by the CBOE to have prices for them included in the electronic option "quote chains" provided to clients by the leading online option brokerages - a couple of examples being thinkorswim by TD Ameritrade and optionsXpress.

The root symbols for expiration months and strike prices are the same for the weekly options as for those with regular monthly expirations, so traders can easily access them any time they look for quotes on the broker's electronic trading platform. [Note: For a detailed explanation of how option symbols work, read Investing Strategies: How to Decode the New Options Trading Symbols in the Money Morning archives.]

The Fourth Option
By now, you're probably ready to ask the obvious question: Why would I even want to trade an option that has a lifespan of seven days or less?

There are several reasons, but the most obvious answer is to take advantage of an expected short-term move in the price of a stock, index or other asset without having to pay for more time than you absolutely need for the anticipated move to occur.

Say it was Friday, Jan. 14, and you knew Bank of America Corp. (NYSE: BAC) - price that day $15.25 - was scheduled to report its fourth quarter 2010 earnings after the close on Thursday, Jan. 20. You expected the earnings to beat the forecasts and thought BAC's stock would most likely rally significantly in response on Friday, Jan. 21.

Had you wanted to play that move with an option in the past, you'd have had three likely choices:

1. Since Bank of America options trade on the regular March-June-September-December (MJSD) cycle, you could have bought a standard March 2011 BAC call option with an at-the-money strike price of $15.00. However, that option had 62 days left until expiration and, even though BAC hasn't been terribly volatile recently, the call was still priced at 92 cents ($92.00 for a full 100-share contract) - 67 cents of which was time premium. That option also had a very low "Delta" - a measure of how much an option's price is likely to change for every $1.00 change in the underlying stock - just 0.5822.

Given those conditions, were BAC's stock to shoot up by $1.00 on the earnings report, the March 15 call would likely rise to just $1.45 - giving you a profit of 53 cents and a return of 57.6%. That's not bad, but it's hardly a spectacular example of the power of leverage given the 6.6% jump in BAC's stock price the $1.00 move would have represented.

2. Had you wanted to go with a shorter-term option, you could have bought an at-the-money call with one of the serial expiration months (or "front" months) - which in this case would have been a February $15.00 call. Though that option had just 35 days left until expiration, its premium on Jan. 14 was still 76 cents ($76.00), and it also had a low Delta of 0.5918. That meant a $1.00 jump in BAC's price on Jan. 21 would have lifted the February $15.00 call price to just $1.20, giving you a profit of 44 cents, or 57.9%. Again, hardly spectacular.

3. The best choice using standard options would have been to buy a deep in-the-money February $14.00 call, which was priced at $1.35, only 10 cents of which was time value. With a Delta of 0.8094, a $1.00 move in BAC's stock price would have pushed that call higher by 81 cents to $2.16, giving you a return of 60% - better, but still not a home run in terms of leveraged return.

Plus, in all three cases, you would have needed to sell the option immediately or risk quickly giving some of your gain back in a subsequent reversal or because of future time-value erosion.
With the new weekly options, however, you could have really harnessed the power of leverage - nearly matching the actual dollar move in the price of the stock, but doing so at a far lower cost and thereby achieving a far greater return.

Specifically, on Friday, Jan. 14, the deep in-the-money weekly BAC Jan $14.00 call was priced at $1.28 - meaning it had just 3 cents worth of time value with seven days remaining until expiration. It also had a Delta of 0.9256, meaning it would likely move about 92 cents for every $1.00 increase in the BAC stock price over the ensuing week.

Assuming the earnings were a positive surprise and the stock shot up by $1.00 on Jan. 21 to $16.25, the Jan. 14 call would have climbed to roughly $2.26 (it would have lost nearly all its time value by then), giving you a profit of 98 cents and a return of 76.56%.

Keep in mind that this is perhaps the most conservative example possible among the 24 stocks on which Weeklys now trade (more will be introduced as 2011 progresses). On an $100-plus stock like Baidu Inc. (Nasdaq: BIDU) or a $350 stock like Apple, with much higher volatility, the potential for leveraged returns over a period as short as seven trading days will be truly amazing.

Of course, buying calls for potential rallies isn't the only possible use of weekly options. If you own shares in one of the stocks on which Weeklys trade and expect an unpleasant earnings surprise or a drop in the broad market that would carry your stock with it, you can buy a short-term put as protection. The cost will be low relative to longer-term standard options and if you choose an in-the-money strike price, the high Delta will give you virtual dollar-for-dollar profits on the put to offset any losses on your stock.

You can also buy relatively low-cost in-the-money weekly puts on the major indices to offset potential losses on an entire portfolio if you fear a short-term pullback.

Finally, you can also sell out-of-the-money weekly covered calls to add income on your stock holdings or out-of-the-money weekly naked put options in order to buy shares at a bargain price within the coming week. Though the premiums will be lower than when selling standard options, you'll only have to wait a maximum of seven days before you get to keep them. And, if the stocks move against you, you can always bail out in two or three days to cut your losses, or cap them by turning the position into a short-term spread play.

Source : http://moneymorning.com/2011/01/19/....

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