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How to Trade Weekly Options

InvestorEducation / Options & Warrants Apr 26, 2012 - 08:55 AM GMT

By: Money_Morning

InvestorEducation

Best Financial Markets Analysis ArticleLarry D. Spears writes: To loosely paraphrase Robert Burns, the best-laid plans of mice and stock traders sometimes go awry.

But with some creative use of weekly options, that doesn't necessarily mean you have to take your losses.

Here's an example of what I mean.


Just under two weeks ago, we suggested a "short iron condor" as a possible short-term strategy for playing the release of first-quarter earnings reports for some of the leading financial stocks, using J.P. Morgan Chase (NYSE: JPM) as a specific example.

As it turned out, JPM's earnings handily topped the estimates - coming in at $1.31 per share versus a projected $1.14, on revenues of $26.7 billion ($24.4 billion had been predicted).

That should have sent the stock nicely higher, giving us a quick gain on our condor - and JPM did indeed try to rally - but then our best-laid plans took a wrong turn.

The broad market turned sharply lower that Friday, with the Dow Jones Industrials dropping 136.99 points and the S&P 500 losing 17.31, dragging J.P. Morgan along with it.

Long story short, over the next five days JPM see-sawed higher and lower - but save for a few moments on Thursday, it never moved out of our $43-$45 maximum-loss range. The trade went south.

But had you been on your toes, you would have noticed this about JPM: In spite of the pressure from a weak overall market, the stock demonstrated strong technical support at the $43-a-share level. Both times it tested $43, it bounced quickly back - a pattern it repeated Monday, when it ignored the broad market sell-off and rapidly rebounded from a lower gap opening near $42.

The rest of this week, it's again traded solidly above $43 a share. In fact, a quick look at the long-term chart shows that - with the exception of Monday - JPM hasn't closed below $43 since March 12th. And, given the healthy earnings and a "powerful buy" rating last Thursday from Zacks Investment Research, it probably won't close below that level again.

At least not in the next week or two...

That's important because J.P. Morgan is one of the 60 or so individual stocks (plus 30 indexes and ETFs) on which "weekly" options are traded.

It's through the use of these relatively new trading vehicles that we can quickly recover the loss we just suffered on our JPM iron condor trade.

A Weekly Options Primer
Weekly options on equities are less than two years old, but they are already highly popular for a variety of purposes, ranging from hedging against short-term pullbacks to speculating on quick price reversals, either up or down.

Perhaps the most popular strategy, however, is selling "weeklys" to generate a steady income stream - or, in our case, offset earlier short-term losses.

For those unfamiliar with them, weekly options were introduced by and trade on the Chicago Board Options Exchange (CBOE). They come in both puts and calls, like regular monthly or quarterly options, and have a range of strike prices surrounding the current price of the underlying stock.

However, they have a lifespan of just eight calendar days - being introduced on Thursday and expiring on Friday of the following week.

For trading purposes, they're designated as Wk1, Wk2, Wk4 and, if a month has five Fridays, Wk5. No weeklys are created expiring on the third Friday of the month since that's when the regular monthly options expire.

Now back to our loss-recovery strategy.

All it involves is selling an out-of-the-money weekly option representing a move opposite the price move you expect in the underlying stock.

In other words, if you think the stock is likely to fall in the next week, you sell the weekly call option - or, if you think the stock price will rise, you sell the weekly put option.

If the stock price moves as you expect ­- or even stays flat - the time value in the option premium will quickly erode, the option will expire the following Friday and you'll get to keep the entire amount you received for selling it.

The risk, of course, is that the stock will move counter to what you expect, putting the option you sold in the money and forcing you to buy it back before expiration - though, given the rapid time-value erosion, that doesn't necessarily mean you'll take a loss on the trade.

The risk is also mitigated by the option's short lifespan - as well as by the fact that you should never use this strategy unless you have a solid reason to think the stock will move as expected, such as JPM's strong technical support at the $43 level.

Even so, you'll have to post a margin deposit to do the trade, the amount of which you can estimate by using the CBOE's "Option Margin Calculator."

(Note: If you want to avoid posting the full margin requirement, you can cover part of it by buying an option of the same type, but further out of the money. That option should cost only pennies, and you'll only have to post the difference between the two strike prices, less the net premium you receive for the option you sell.)

Using Weekly Options to Recover Your Losses
Had you been aware of this play when you closed your JPM short iron condor last Thursday, you could have immediately sold the JPM AprilWk4 $43 put.

With JPM at $43.22, that put was trading around 55 cents, or $55 per full 100-share contract, enough to offset nearly all of the 82-cent loss you took on the condor. The margin requirement for the trade would have been about $842, which seems a bit steep - but if you get to keep the full $55, that's a return of 6.5% in just eight days.

Obviously, it's too late to do that now. By the time you read this, the AprilWk4 put premium will likely be less than a quarter of last Thursday's levels - even if JPM's price hasn't changed at all.

But that's the nice thing about weekly options - you get another chance to sell the appropriate JPM MayWk1 put today or tomorrow. Merely adjust the strike price accordingly, based on the underlying stock price at the time.

Then, keep repeating the strategy every week. You'll quickly recover your full condor loss, after which you can start generating a regular weekly income from J.P. Morgan - without even owning the stock.

As an alternative to buying back the put if JPM does move against you, you can choose to let it be exercised, forcing you to buy the stock at $43 a share - less than where it's trading now.

You can also use this strategy with any of the other stocks on which weekly options trade, generating income from them for far less than you'd have to invest to actually buy the shares.

Source :http://moneymorning.com/2012/04/26/how-to-trade-weekly-options/

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