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How to hedge with weeklies--or not

Chris McKhann (chris.mckhann@optionmonster.com)

Some have compared option trading to a three-dimensional chess game, with time as one of those dimensions. Choosing the right expiration to fit your needs is of utmost importance, whether you are speculating or hedging.

The weekly options have been incredibly popular, for instance, but are they the best bet when it comes to hedging? They can be tailored for very short time horizons and are "cheap" compared with their monthly cousins, but price is just one part of the equation.

Earnings season is upon us, and that is one of the big drivers of weeklies. We can look at Wells Fargo as an example, ahead of its quarterly results on Friday. WFC is trading at $35.17 at the time of this writing (Wednesday), just off its 52-week highs above $36. Investors who own the stock might want to hedge their positions through the earnings announcement, as the shares have seen some big one-day moves.

Wells Fargo's Weekly 35 puts are going for just $0.45. (Another advantage of weekly options is the new $0.50 strikes , but for consistency we will stick those that are in full-dollar increments.) The regular monthly October 35 puts that expire next week are priced at $0.56, and the November 35 puts are going for $1. So the Weekly 35s appear to be the "cheapest" hedge by price alone.

But wait--we will also want to look at the implied volatility to measure the relative value of those options. The implied volatility is 45 percent for the Weekly 35 puts but 29 percent for the monthly October 35s and 24 percent for the November 35s.

The average implied volatility for WFC, as seen in the chart at right, is 23 percent--essentially an average of the options. But the 30-day historical volatility is 20 percent while the 10-day reading is just 18 percent, up from 11 percent a week earlier.

The 30-day historical volatility hasn't been above 45 since early December. And the data shows that earnings aren't usually what drives volatility much higher.

The upshot: In this context, the weekly options may appear cheap in dollar terms, but they don't look so good with volatility analysis.

We can look at longer-term hedging as well, using the SPDR S&P 500 options. In the case of the SPY, the weekly options have the lowest implied volatility of any expiration.

With the SPY at 143.43, the Weekly 143 puts cots $0.49 and have an implied volatility of 13 percent. The October puts cost $1.09 and have an implied volatility of 13.3 percent. And the November options cost $2.46 and have an implied volatility of 13.7 percent.

Traders who want a continuous hedge might see those weekly options as the cheapest choice, based on both cost and implied volatility. But one must remember that time decay increases exponentially as you approach expiration.

So we essentially pay $0.24 per day for hedging with the weekly options. We pay half of that, or $0.12 a day, for the October contracts and just over $0.06 a day for the November options. This is one reason that many institutional traders go out a bit in time for their hedges, depending on the objective.

Obviously weekly options have their place and can be a great vehicle for speculating or hedging. But I still believe that volatility and time analysis is worthwhile.

Typically you should only buy something that you think is undervalued--or fairly valued in the case of hedging, as you are less price sensitive in the latter case.

(A version of this article appeared in optionMONSTER's Education newsletter of Oct. 10. Chart courtesy of  iVolatility.com.)

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