Why I Love Selling Weekly Options
Selling weekly put options is one of my favorite techniques for generating income from the stock market. There are several reasons for this.
One, by selling weekly options we leave the least amount of time to expiration. The closer you are to expiration, the quicker that time value erodes. That means more premium in your pocket when compared to selling longer dated options.
Two, stocks are hard to predict. People have been trying for over 100 years to figure out how they can predict stock movements with accuracy. But when we shrink the time down to a week or less, stocks are much more predictable. It’s a lot easier to say that the stock will stay below a certain level within the next three days or stay above a certain level for the next two days.
So with all that said, I wanted to walk you through a trade that I just started on Apple Computer.
As always, it begins with the chart. As you can see below, the price of Apple has been rising for quite a while. The blue line in the chart is the 50 day moving average. This is a pretty standard measurement to use for determining support and resistance. You can see that right as October began, Apple dropped down to the 50 day moving average, but then bounce upward. This is exactly the kind of situation we want to see when selling puts. The 50 day moving average in this case is providing support, meaning that it will be difficult for the stock to break below it. For AAPL in particular, there are about a million hedge and mutual funds out there waiting for such an opportunity to buy more.
I noticed this chart pattern this morning when I was checking through my list of stocks that have weekly options. Since the chart looks good. It’s time to investigate deeper and look at the options.
The Options Chain
As you can see in the image above, I went into my brokerage account at optionsXpress and looked at the valuation of the various put options for Apple.
The first column in the table is the strike price, which is the execution price for the option.
The second column is the last traded price, which you can pretty much ignore for options. Options might trade frequently, or they might not. Since their value depends primarily on what the underlying security is doing, it doesn’t matter whether they have traded recently or not.
The third column is the bid. The bid is very important because this is probably how much will be selling your option for.
The fourth column is the ask which pretty much set the limit for the most you’ll get from the option.
The fifth column is the theoretical value, which is crucial.The theoretical value is calculated based on certain probabilistic mathematical models. The details aren’t that important, what you need to know is that they represent what the option should cost based on the current market conditions.
You can see that for the strike prices 655 and lower, the bids and the asks are higher than the theoretical values. This is what we want to see, it means that the options are overvalued compared to what the stock has actually done recently. When something is overvalued, that’s when you want to be selling it!
Based on the chart and the fact that there is only one day to expiration, I chose the 650 strike price.
So that’s step two.
The Bull Put Spread Trade
Now I have a decision to make. I can sell the put naked, meaning that I will hold cash my account against the chance that Apple goes below 650 by the end of tomorrow. This will work, but the downside is that for a price like $650, that’s a lot of cash to hold. For each contract that I sell I would need to have the $65,000 in cash in order to make about $50. That’s not a great use of my capital.
So, I have to look for other ways to enter this position. The easiest thing to do is to buy a lower strike price put and create a spread. Since the spread uses puts and has a bullish bias, it’s called a bull put spread.
What ends up doing was buying the 645 puts. This lowered my premium per contract to $14, but each contract now requires me to hold $500, the difference between a strike prices times a hundred, instead of $65,000.
$14 on an investment of 500 is a yield of 2.8%. $50 on a $65,000 investment is far, far less than 1%. So clearly the spread trade was the better choice here. It’s even better than my original AAPL trade post.
Regardless of which way you go, it’s extremely unlikely that Apple will crash below $650 by the end of trading tomorrow. This is why I love selling weekly options. You can construct extremely high probability trades. In the stock market, it’s all about the odds. You’re not going to get every trade right, but you can stack the odds in your favor. As long as you do that and have favorable risk versus reward ratios, then you can continue to create income for yourself just by sitting in front of your computer.
As you can see in this example, I sold 20 contracts. I chose 20 just because it makes for a $10,000 margin requirement, which is a very conservative allocation for my portfolio. So that’s another 280 bucks in my brokerage account provided Apple doesn’t crash 17 points and through all support in the next day and a half.
But the absolute numbers really aren’t as important as the percent returns. Where else can you get a 2.8% return in two days? If you can do that every week, then you’ll blow the professional money managers out of the water, all the while taking minimum risk.
See you tell me, why would you ever buy a stock again?