Weeklys: Trading Short-Term Options in the Red Zone

Decisions are a little more pressing. And just as with football, the way you perform in the red zone can determine your success. Some teams thrive there, and some traders love those few days before expiration. The product that lets them play there is known as “Weeklys"—exchange-traded options on stocks that expire in just one week. Weeklys are created on Thursdays and they expire the following Friday. Set! Hike!

Weekly expiration options were introduced a few years ago, and their popularity among traders is expanding rapidly. The reason? Weeklys offer the ability to make very tailored speculations on short-term price moves in the stock. With fewer days to expiration, they're less expensive than other options at the same strike price in further expirations. And they give you a lot of bang for the buck, because if the underlying stock or index makes a big move, Weekly prices can change by a much larger percentage than further-dated options. That's what makes them “red zone” trades. If the trade in the Weekly options goes wrong, there's no “it'll come back someday"—unless “someday” is this coming Friday.

What do I mean? Let's use an option pricing formula to arrive at some theoretical values. (The option pricing model we're using is Bjerksund-Stensland. All theoretical values in the following example were derived using the theoretical pricing tool found in the Trade page of the thinkorswim^® from TD Ameritrade platform. See callout, left.) Let's assume we're looking at a $100 stock with a volatility of 35 %.

If the stock price moves from $100 to $101 (assuming no change in volatility), the 100 strike Weekly calls with seven days to expiration theoretically would go from .90 to 1.44. Meanwhile, the 100 strike calls with 21 days to expiration would go from 2.23 to 2.76. The Weekly options rose 0.54, or about 60%. The 21-day options rose 0.53, or about 24%. Thus, Weekly options have the potential to increase by a greater percentage for the same price change in the stock.

Big Bang, Small Buck

What makes the Weeklys move so much? The short time to expiration means that Weekly options have relatively high gamma. That high gamma means that their prices respond very quickly when the stock or index price changes, whether up or down. Gamma measures how much an option's delta moves when the stock price changes; delta measures how much the price of the option changes.

A good way to think about delta is how much the option “acts” like stock. When gamma is high, a small change in the stock price increases the delta, pushing the option to act more like stock as it changes closer and closer to parity (dollar for dollar). That's what accounts for the very high percentage appreciation you can see in Weeklys options. The high gamma makes them interesting trades for earnings announcements or other news releases. Let's say you believe the stock will have a big price change when the news comes out. It's the Weekly options that will have the largest percentage changes if you're right.

If that's the case, why wouldn't you just buy Weekly options all the time? Well, the less time there is to expiration, the less likely it is that a big move is going to occur. A longer-dated option gives the stock more opportunity to rise. The short amount of time with Weeklys means that their decay, or theta, whittles their extrinsic values down very quickly. Along with the high gamma, Weeklys have commensurately high theta. If the stock does not make the price move you're hoping for, that Weekly option's price will go from cheap to cheaper thanks to time decay, and much of the time, there's no turning back. That works in favor of short options positions, but your longs are likely toast.

A Case For Buying

You might be asking yourself, “But if you're speculating on a short-term change in the stock, why use the Weeklys instead of trading the stock? “It's true that stock doesn't expire and doesn't suffer from time decay, but it uses a lot more trading capital than a Weekly option, and it can have a lot more risk. If you were going to buy 100 shares of that $100 stock in the example, the margin requirement would be $5,000. But the weekly 100 strike call would cost you only $110. And let's say the stock drops in price. The max loss on the long Weekly call is $110—as opposed to $10,000 on the long stock. While the stock position has advantages, it also has greater risk.

So how about just buying options with a further expiration date? You could buy more to get the gamma equal to the Weekly position, and the time decay would still probably be lower. The risk here is that the larger position in options with a further expiration date has a much higher vega, or sensitivity to changes in implied volatility. Remember when I said that Weeklys let you tailor the speculation? Weekly options have low vega, and don't move as much when volatility goes up or down. That means that you can focus more on what the stock price is doing. With longer-dated options, you have to be aware of what volatility is doing as well.

A Case Against Selling

Now, the reason that every trader doesn't just go out and short Weekly options to take advantage of the steep time decay is that the lower price of the Weeklys makes the absolute amount of decay relatively lower. Sure, the rate is high, but the overall amount is smaller. Just as an offense has a running game and a passing game, each with its own particular risk and potential reward, buyers of Weekly options take the risk of that big move in the stock not happening while they battle negative time decay. Sellers have to decide whether the smaller credit they get from shorting the Weekly is worth taking the risk of a big move in the stock that would create a huge loss in that position.

Getting in the Game

So, ready to start trading Weeklys as part of your game plan? Here are some things to consider during the huddle:

1. CURRENTLY A SMALL BASKET Weeklys are available on more than 20 different stocks and several indexes. Individual stocks sometimes have their biggest price swings around earnings numbers. If you're buying Weekly options to speculate on a big price move on earnings, double-check to make sure the earnings are announced before the Weeklys expire (see callout, left). Keep in mind that if you guess wrong and the position moves against you, you could lose the entire investment amount spent on the option.

2. HOW TO SHORT If you want to try to take advantage of the Weeklys’ time decay, you could consider shorting Weekly option spreads in the index products. You can see those symbols on the public watchlist as well. The index products tend to be less volatile than individual stocks, and can be a way to test out short option strategies. Bear in mind that some short strategies can carry unlimited risk. So be sure to understand all relevant risk factors and whether such strategies are suitable for your portfolio.

3. WATCH FOR EARLY SETTLEMENT Some Weekly options are based on cash-settled indexes such as the OEX, XEO, DJX, and SPX. The DJX and SPX Weekly options stop trading on Thursday afternoon and settle on Friday morning. For more information, check the Weekly option specifications on the Chicago Board Options Exchange website at www.cboe.com.

What should be clear from the advent of Weekly options is that equity markets are no longer targeted to just long-term investors. As options are becoming increasingly popular with traders, the industry is scrambling to find ways to quench their thirst for capitalizing on short-term events that move markets. Heck, recently, the CBOE petitioned the SEC to include options that expire daily in its arsenal of products! Who knows if that'll happen, but if “Dailys” are on the horizon, so much for the red zone—you're literally at the goal line.