Options, used wisely, can and do hedge market risks. Many strategies, from the basic covered call to uncovered puts, covered strangles, collars and even butterflies or condors, all can be used as risk-neutral hedging strategies. The percentages go way up in your favor when you combine conservative strategies with short-term expiration (for short positions), proximity (or underlying price to strike and of underlying price to resistance or support) and identification of reversal signals with confirmation.
That’s basically the way that options can be used to move the probabilities in your favor.
Are there differences between probabilities and odds? It’s the same thing, but gamblers like to think of winning and losing as playing the odds, and they invariably believe they can overcome the averages. Even a roulette bet on black or red, often thought of as a 50/50 bet, is not quite that favorable. With the zero and double-zero in mind, the odds of winning on a black or red bet are 47.4%, not 50%. There are 18 black, 18 red and 2 green outcomes, so black or red is an 18 out of 38 probability (18 ÷ 38 = 47.4%). This means that if you bet on either red or black consistently, you will eventually lose.
The odds are slightly better with weekly options, but it’s only a 50-50, or an even bet.
First introduced in 2005, weekly options exist for a short term only, just 8 days. They are set up every Thursday and expire the following Friday.
At first glance, weekly options are very cheap. But it could also be a sucker bet, just like the seemingly favorable rules on many casino games. For example, you can buy a weekly call option and accept the odds of the underlying price moving high enough by next Friday to make it profitable (meaning intrinsic value outpaces time decay). The same observation works for weekly puts, but in the opposite direction.
You are giving up the advantage of a longer term in exchange for a cheaper premium. But for a long position, this seems like a long shot, to use the terminology of gambling.
For short options, the odds move very nicely in favor of the trader.
Because time decay will be rapid, opening a short weekly option can be very profitable. The dollar amounts are not huge, but the annualized return can take you to double digits. In fact, on average, options lose one-third of remaining time value between the Friday before expiration and Monday. This is because three calendar days pass but only one trading day. This is a fact often overlooked by traders: Time decay takes place every day, whether the market is open or not.
This represents a great value. Going short, either with calls or puts, is a great advantage using weekly options.
A few suggestions for increasing the odds (probability) in your favor:
Build in a buffer when possible. This is a distance between the option’s strike and current price of the underlying. By keeping the position out of the money, you receive less for the position, but you also reduce exposure to exercise. As the underlying moves toward the money, the OTM call or put can be closed or rolled to avoid exercise. But there is a good chance that time decay will outpace intrinsic value.
Pay attention to resistance and support. The most advantageous timing to open a short option is when the underlying price moves above resistance (timing to open a short call) or below support (open a short put). Assuming the price does what it usually does – retrace back into range – this timing maximizes your probability. This is especially true if the move outside of the trading range occurs with a price gap.
Look for reversal signals and confirmation. Pay attention to traditional Western signals like double tops or bottoms or island clusters; candlesticks; volume spikes; moving average convergence; and momentum oscillators. Only act when you find the signal and confirmation; this increases your chances for success.
- Pay attention to strength or weakness in the trend. The best reversals happen when a previously strong trend reaches a plateau, slows down, and then turns in the opposite direction.
Weekly options can be summarized with the long and short attributes in mind. Long traders must fight against time decay and time. Short traders benefit from time decay and time. With the four guidelines in mind, what otherwise could be 50-50 odds are moved nicely in your favor.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.