The best policy is to use strategy, influence, and the trend of events to cause the adversary to submit willingly.
-- Sun Tsu, The Art of War
I trade a lot of options relative to my other trading, especially when I want to invest in a company instead of trading the stock of the company. I normally sell, or "write" options, instead of buying them.
Writing an option instead of trading the stock lowers my risk while at the same time providing some of the same benefits of being an insurance company. I get to collect a premium and unless something happens I get to keep all or some said premium. Most people, especially retail traders, think of options as something they buy and hope the price moves in their direction so they can make money. Most options are sold by market makers and other large players. Sellers of options are betting that either the price direction will go in their favor or if not, it will not move against them faster than the time premium decays.
I am working on a multi-part article that goes into the details of trading options and how to avoid the plethora of landmines and obstacles designed to separate you from your money. While working on the article I traded a stock known as China MediaExpress Holdings (OTCPK:CCME) during the recent massive sell-off (I also traded CCME options when the price spiked right before the fall). I realized that the sell-off was so extreme, that the option premium would be increasing because of the risk involved with writing the contracts combined with the increased demand of buyers wanting to either use options to be short CCME or to protect themselves from further losses of stock they already owned and did not want to sell.
This article is about one type of option strategy and is not a primer on buying or selling options. I will go over how one can profit from a large movement in the price of a stock and at the same time have a lower risk than trading the stock outright. In this example we will be exploring one strategy, shorting CCME puts instead of buying stock.
The difference between the price of a stock and the strike price determines if the option is in the money or out of the money. Taking in account for this difference which can and often is a negative number and adding in the current option price you have what is known as the risk premium or implied volatility (IV), In the case of CCME on Thursday the IV shot to what I consider to be sky high and went over 200%, which I find rare in highly liquid stocks. I did not see as high an IV with BP during some of the crazy days it had last year. Because of this high IV, I covered the stock I bought in CCME and started to short put options on CCME. First with the Feb 13th options and then as the price moved down I moved to the Feb 11s. For the sake of keeping the math simple, I am going to use round numbers. So that it can be done without a calculator but still maintaining the concept.
At the same time that the CCME stock price was around $13 a share the Feb 13 put options where trading around $2 each. That means that CCME had to close below $11 on the third Friday in February for me to lose money ($13 strike price less the premium received of $2). At the same time, if I hold on until the third Friday in February and the price of CCME is above $13 per share I get to keep the entire premium of $2 per share (a gain of about 15% over two weeks less commissions). If the price closes somewhere between $11 and $13 then I gain a relative profit depending on the closing price. Money can also be made (or lost) sooner than the expiration date by closing out the transaction early.
The important point is that if I am going to buy the stock anyway (which I was already trading) I may be able to short put options and make as much money as I would have by buying the stock and have a lower risk doing so.
The setup is very critical when using options. When I trade options I have a list of items I need to be in place to have a successful trade. With CCME I had all the needed items for my setup in various degrees.
- CCME was in a crazy high volume free fall ( Check – CCME was down over 30% for the day)
- CCME had enough option trading liquidity that I would be able to trade as many options as I wanted and I expected that to continue. (Check – somewhat weak check here. The bid/ask spread was wide so I knew I would have to be able to sell at the offer and buy at the bid if it was going to work. All sales to sell the puts were done at the offer or near the current offer)
- CCME’s IV was high enough, that if I was wrong I would still be able to get out at or near break even by holding a few days. (Check - The high volume price free fall sent the IV through the roof)
- Commissions would not totally ruin the trade. (Check - my broker generally charges about $1 per contract per side after all expenses )
- I was going to buy this stock anyway because I felt that it was oversold and would bounce higher ( Check – I was already long and closed out the position in exchange to selling put options)
The risk in buying a falling knife like CCME is that it implodes and the company goes out of business. With the price falling as fast as CCME was, many investors may have been thinking that was going to happen. If you bought the stock at $13 thinking it will gain in value, you would be risking $13 per share (plus commissions and transaction costs, but I will leave commissions out for the rest of this article). But if you feel they have it wrong and you’re looking for less than a $2 gain from the trade, options become very attractive. When I sold the $13 Feb put for $2, I was no longer risking $13 per share but rather only $11 per share. This reduces my overall risk by more than 8%.
Many think of buying options to reduce risk, when you can also use options to reduce your risk by selling options relative to the stock it represents. Further, by selling the option with such a high IV all that is needed to make money is for the market to calm down. The price of the stock does not need to go up, Just stabilize. Friday for example, one day after I sold the CCME puts, the IV went from over 200% the day before to under 200% and floated in the 180-190% range for most of the day. The fear level (IV) of CCME’s stock price declining further with investors was falling, causing the price of the options I sold to go down. This was expected as the price would have to continue to fall for the fear to be maintained. When the price of CCME stopped falling the fear started to fade.
As an added bonus and the reason why I started to trade CCME in the first place was that CCME started to go up in price. Once the price of CCME went above $13 per share on Friday, the options that I sold lost all of the intrinsic value and were left with only time value. As the time value is largely made up of the perceived fear of movement and the fear was falling, the options fell in price too. I was then able to buy back the options I sold the day before at a nice gain, and did not expose myself to as much risk as I would have, by buying the equivalent number of shares of stock and holding overnight. It should be noted that I also did limit my potential gains based on the time, number of shares and price of CCME relative to the options I wrote. I made as much as my target gain would have been with CCME stock, so I count this as a successful trade. One could have used the mirror image with calls if they wanted to short CCME. If a trader wanted a lower risk profile and / or their broker did not have shares to short, options could have provided a vehicle to get there. I will cover that technique in another article.
The real power of this strategy over buying CCME stock is that if the price has a big drop and just sits there for days afterward stuck in a range, the options are likely from my experience to fall in value allowing the writer/seller to make money without the stock moving higher. As the fear of continuous falling abates the demand for puts diminishes and the IV falls with the price.
Using this strategy allows the trader or investor the ability to try to catch that proverbial falling knife with at least a thin, but somewhat protective glove on, instead of using a bare hand. Hopefully this strategy will allow you to avoid some cuts that you would have received otherwise.
Implied Volatility (IV) – A measurement of risk in terms of how much a stock may move in price in a given amount of time. Higher Volatility means the market is pricing in larger moves of the stock.
Put option – convey the right but not the obligation to sell a stock at a certain price within a certain period of time, regardless of the current price of the stock (American Style).
Call Option - convey the right but not the obligation to buy a stock at a certain price within a certain period of time, regardless of the current price of the stock (American Style).
Time premium decay – The value of the time premium lost each day (and nearing the expiration, measured in hours, minutes). For example if an option has a time premium of $1 and there are 4 days of trading before expiration, the option can be expected to lose on average $.25 per day, all else being equal.
Time Premium – The amount of value an option has over and above the intrinsic value. If the strike price of a put option is $12 with a stock currently trading at $13 and the put option is trading at $2, the time value is $1 ($13 stock - $12 put strike = $1 intrinsic value + $1 time value = $2 option value).