Weekly Options – Tread carefully

[Update 2012-10-26: This trade was successful. The price of AMZN fell for most of the week, recovering on Friday, and finishing at 238.24. This was well below my strike price of 260. Result: I collected $969 in premium. :)]

Besides my regular portfolio of options, I will occasionally dabble into Weekly options. I don’t usually utilize a spread. By not capping one end of the price-profit chart, I have assumed the risk of unlimited losses.

My strategy for Weekly options is to always sell the option. (i.e. A Short Call)
I want to gain income/premium. The higher the implied volatility is, the better the payoff. The upcoming earnings announcement will pump up this volatility level even further.

Let’s look at a trade of a ‘weekly’ option that I executed today.

I sold short 3 AMZN weekly Oct 26 calls – strike 260 @ $3.23.

At the time of my trade, Amazon (AMZN) was 240.50. (It closed today at an ‘even’ 240.00) The implied volatility was 77%. Normally, this option, looking forward a month or two, would have a volatility of around 40%. Amazon reports earnings on Thurs Oct 25.

Here are some scenarios for this transaction.

1. The stock price stays below 260.
The 260 call option would be out-of-the-money and would expire worthless.
I would keep the $969 premium. (3 x 100 x 3.23).
In this scenario, the price rises no higher than 8.3% after earnings are announced.

What would happen if Amazon announces knock-them-out-of-the-park earnings?

2. The stock price jumps 9.7% to 263.23.
That happens to be the break-even point of this transaction (260 + 3.23).
I would lose the premium and the net result would be zero.

3. The stock price jumps 12.5% to 270.00.
I would lose $2,000 on this transaction.

4. The stock price jumps 16.6% to 280.00.
I would lose $5,000 on this transaction.
I would need 5 similar positive transactions to make up for this disaster scenario.

As you can see, this is very risky.

Why would I do this?
I believe that the probability of this stock finishing out-of-the-money is higher than the pricing action would indicate. i.e. I have a positive Expected Value (EV) for this trade. Likewise, I believe that the probability of the disaster scenarios happening, is far less than the pricing model indicates.

I wouldn’t recommend this ‘weekly options during earnings reports’ strategy to others. You might even be correct to call this gambling. However, I only do this occasionally. And I only do this on a small portion of my portfolio. I am comfortable with this level of risk.