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August 1, 2010

7 Dangers of Weekly Options

Weekly options are here to stay as I mentioned in my previous article on the seven benefits of weekly options.   The CBOE has a page dedicated to weekly options with lots of good information.  In case you missed the CBOE link, here it is again: http://www.cboe.com/weeklys

Most things in life, as in trading, are a balancing act.  With most advantages you have to give one up to get another one.

Here’s a list of seven dangers of weekly options:

1. High Gamma

Gamma is the rate of change of Delta.  It’s essentially how curvy your price chart is.  The straighter the lines, the less gamma you have.  In the last week of trading, options are quickly are running out of time premium which is essentially the distance between the current price risk line and the expiration line.  As time passes, the curvy lines collapse to the expiration shape.  This processes accelerates daily and is at a maximum the day of expiration.  This is when your charts have the maximum curvedness and the highest gamma risk.

So how does this affect me?

Profits can evaporate VERY quickly and even turn into losses with very short movement of the underlying instrument.   This is especially true if your risk graph is “pointy” and the point is at the money.  This would be a butterfly or calendar shape.  Expiration week is often called “Gamma Week” as Gamma is at it’s maximum values.  So your Profit and Loss can change VERY quickly.  This is probably the reason most people trading weekly options are trading strategies with relatively flat expiration risk charts near the current price.  This reduces the Gamma effect (but doesn’t eliminate it).

2. Price Risk

This is related to Gamma Risk.  As prices move, gamma changes quickly. The two are related.  In addition to the gamma risk from the underlying price moving, you have the risk of a large price move that you can’t defend against.  Gap moves or very fast markets for instance.  WIth longer term options you have time to adjust and reset your trade.  With weekly options,  alternatives are slim to none.  There often isn’t enough time premium with the strikes you have to work with to roll or adjust your position.

3. Fewer Risk Management Possibilities

This is partly related to price risk as discussed above.  Since weekly options have a very narrow range of movement, the strikes you have to work with are proportionately farther apart than they are for longer term options.

What do I mean?

Imagine you are trading a stock with $2.50 strike separation.  Suppose the 5 days, one standard deviation move is $1.50 and the 55 day, one standard deviation is $5.00.   The 55 day option has two strikes up and down to adjust to.  The 5 day option has none as $2.50 strike width is greater than the one day, one standard deviation move.

4. Liquidity

This is improving but weekly options are still relatively new.  There are very few underlying symbols you can trade weeklies but it is growing steadily.  Some strikes have sufficient liquidity but keep this in the back of your mind as you may find situations with in-the-money options have MUCH less liquidity than you realize so the bid/ask spreads will widen and execution will be difficult.

5. Execution

Related to liquidity.  If you can’t get executed at the mid price, giving up $0.05 or $0.10 from the mid price to get your trade executed can have a VERY large effect on your return.  For instance, if you sell an iron condor for $0.40 but have to give up $0.10 to get it executed, you just gave up 25% of your premium!  Many of our students have to be very patient to get their trades on at a good price.  Realize if you have to get out of your trade,, you might have to give up all of the premium you collected if it’s a fast market!  $0.40 isn’t a lot of extra room to play with.

6. Commissions

Since your frequency of trading is higher, your broker will love you as you’ll have a LOT more commissions you generate.  Make sure you use an option broker with good rates oxycontin 80 mg.  Even $1.50/contract can hurt with weekly options so try to find a broker with $1/contract with no per ticket charges.  Remember to factor this in as $1/contract in and out is $2 or $0.02.  If you do an iron condor and close it, that’s 4 legs times $0.02  or $0.08 of your premium for commissions!  Combined with $0.10 total slippage ($0.05 each way), that’s $0.18 of your $0.40 premium collected or nearly half of the premium you collected!  If your total slippage is $0.20 ($0.10 each way), that’s $0.28 in slippage and commission for $0.40 of premium…. or 70% of your premium collected!!!  BEWARE!

7. Temptation to let options expire worthless

We normally exit before expiration as there are substantially increased short term risks as you approach expiration day as we have discussed.  There is a strong temptation to let options expire worthless so you don’t lose with slippage and commissions.  I would be VERY VERY cautious doing this.   Part of trading is risk management.  We take options off when the risk to reward is too high.  It’s easy to rationalize that it’ll be ok if I just let this option that’s worth $0.05 expire.   Most of the time that’s true.  When you have a big market event, you will wish you had taken that risk off the table.

Dan Sheridan knew someone in the pits years ago who was ready to retire and had a LOT of VERY cheap puts just before expiration.  Instead of taking them off and retiring, he left them on and lost millions of dollars as the market was crashing.  It delayed his retirement by several years!

Don’t rationalize your risk management away based on commissions and slippage!

KC-135 Refueling an F-15

KC-135 Refueling an F-15

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Tom Nunamaker

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