The Use And The Abuse Of The Weekly Options

Options trading is becoming more and more popular every year. The options become more liquid and more traders use them for hedging, speculation, income etc.

What are Weekly Options?

For those less familiar with options, they expire on the third Friday of every month. Weekly options, first introduced by CBOE in October 2005, are one-week options as opposed to traditional options that have a life of months or years before expiration. New series for Weekly options are listed each Thursday and expire the following Friday.

Not every stock or index has weekly options. For those that do, it basically means that every Friday is an expiration Friday. That opens tremendous new opportunities but also introduces new risks which can be much higher than "traditional" monthly options.

Let's see for example how you could trade Apple (AAPL) using weekly or monthly options.

Are they cheap? Lets buy them.

Apple took a hit after their recent rare earnings miss. Many people think that the selloff is overdone. They want to use the recent pullback as a buying opportunity. The stock closed at $585.16 on Friday, July 27, 2012. Looking at ATM (At The Money) options, we can see that August 18 (monthly) calls can be purchased at $10.10. That would require the stock to close above $595 by August 18 just to break even. However, the weekly options (expiring on August 3, 2012) can be purchased at $6.15. This is 40% cheaper and requires much smaller move.

However, there is a catch. First, you give yourself much less time for your thesis to work out. Second and more importantly, the weekly options are much more exposed to the time decay (the negative theta).
The theta is a measurement of the option's time decay. The theta measures the rate at which options lose their value, specifically the time value, as the expiration draws nearer. Generally expressed as a negative number, the theta of an option reflects the amount by which the option's value will decrease every day. When you buy options, the theta is your enemy. When you sell them, the theta is your friend.

For the monthly 585 calls, the negative theta is -$0.22. That means that the calls will lose ~2.2% of their value every day all other factors equal. For the weekly calls, the negative theta is a whopping -$0.43 or 7% per day. And that number will accelerate as we get closer to the expiration day. You better be right, and you better be right quickly.

Buying is too risky? Maybe selling is better?

If this is the case you might say - why not to take the other side of the trade? Why not to use the accelerating theta and sell those options? Or maybe be less risky and sell a credit spread? A credit spread is when you sell an option and buy another option which is further from the underlying price to hedge the risk.

Many options "gurus" ride the wave of the weekly options and describe selling of weekly options as a cash machine. They say that "It brings money into my clients account weekly. Every Sunday my clients access their accounts and see + + +.” They advise selling weekly credit spreads and present it as a "a safe option strategy because we’re combining an option purchase with an option sale resulting with a credit into your account".

This strategy can work very well.. until it doesn't.

Imagine for example someone selling a 133/134 SPY credit spread on Thursday with SPY below $132. That seems like a pretty safe trade, isn't it? After all, we have just one day, what could possibly go wrong? The options will probably expire worthless and the clients will see more cash in their account by Sunday. Well, after the market close, good news from the EU summit took traders by surprise. The next day SPY opened above $135 and the credit spread has lost 100%. So much for the "safe strategy".

By the way, this was a real trade recommendation from one of the options "gurus". He is charging $2,500 for his advice.

So what is the biggest problem with selling the weekly options? The answer is the negative gamma.

The gamma is a measure of the rate of change of its delta. The gamma of an option is expressed as a percentage and reflects the change in the delta in response to a one point movement of the underlying stock price. When you buy options, the gamma is your friend. When you sell them, the gamma is your enemy.

When you are short weekly options (or any options which expire in a short period of time), you have a large negative gamma. Any sharp move in the underlying will cause significant losses, and there is nothing you can do about it.

The Bottom Line

So is the conclusion that you should not trade the weekly options? Not necessarily. They can be a good addition to a diversified options portfolio - as long as you are aware of the risks and allocate only small portion of the account to those trades.