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On p.474 of his book "Chart Your Way to Profits," Tim Knight makes a few common sense points about speculative options buying:

  • Start small (since options often expire worthless).
  • Avoid out-of-the-money-options (buying in-the-money options is safer and more conservative)
  • Avoid nearby expiration dates (to avoid theta burn and give your position more time to work out)

I've been following each of those guidelines in my recent speculative options bets, and I've added a fourth one this year: buy options at a discount to model estimates of their fair market value. I put limit orders in for a couple of options after the close Tuesday that met all four guidelines. More on those below, but first a quick clarification, since I've written about options in the context of hedging in recent posts: the trades for which I placed these limit orders are speculative directional bets, not hedges.

Hedging versus Betting

If I were hedging, I would enter the symbol of the stock or ETF I was looking to hedge in the "symbol" field of Portfolio Armor (available in Seeking Alpha's Investing Tools Store and as an Apple iOS app), enter the number of shares in the next field, and then enter the maximum decline I was willing to risk in the "threshold" field. Then Portfolio Armor would use its algorithm to scan for the optimal puts to give me that level of protection at the lowest cost.

On rare occasions (I've seen it happen once, so far) the optimal puts Portfolio Armor presents might be in-the-money; in most cases though, they will be out-of-the-money. Since I'm making directional bets in the cases below, though, and not hedging, I placed limit orders on in-the-money options that were close to the current prices of the underlying stocks. This makes sense for directional bets (when you are willing to pay more to reduce the odds against your bet) but would be sub-optimal in most cases for hedging (when you want to get a certain level of protection at the lowest possible cost).

For the bearish bet, I started by scanning for stocks that looked weak technically and fundamentally. Then I looked for in-the-money puts on them several months out, and compared the current bid-ask prices for them with the estimated fair market value of them via a Black-Scholes calculator.

For the bullish bet, I did the reverse: scanning for stocks that looked strong technically and fundamentally, and looking for in-the-money calls priced below the Black-Scholes estimates of their fair market value. In both cases, I tried to avoid stocks with heavily-traded options, thinking that there would be fewer inefficiencies in the pricing there. Nevertheless, in most cases, the bid prices of the options turned out to be higher than the Black-Scholes estimates of their fair market values. The ones below were a couple of exceptions.

The Bearish Bet

Delcath Systems, Inc. (NASDAQ:DCTH) is a development stage medical device company. This is the sort of stock I wouldn't short traditionally (at least not without being hedged1) -- news of an FDA approval or of a deal with a major partner could lead to a big spike in a stock like this. But as of now, this looks weak technically and fundamentally, and by buying puts instead of shorting it, my potential downside is capped at the cost of the puts.

DCTH has no revenue, negative trailing earnings, and negative forward earnings estimates, with a forecast PEG ratio of -0.78.

Audit Integrity rates DCTH as having an "average" Accounting & Governance Risk (AGR®) score.

DCTH closed at $7.27 Tuesday. The Black-Scholes estimate of the fair market value of its $8 strike, December 2011 puts was $3.37. The bid-ask on them was $2.21-$2.39. I put in a small limit order at $2.30.

The Bullish Bet

Owens & Minor Inc. (NYSE:OMI) is a medical device distributer.

OMI is profitable, trades at 0.26x its trailing twelve months' sales, and has a forecast PEG ratio of 1.63.

Audit Integrity rates OMI as having a "conservative" Accounting & Governance Risk (AGR®) score.

OMI closed at $33.79 Tuesday. The Black-Scholes estimate of the fair market value of its $30 strike, December 2011 calls was $4.23. The bid-ask on them was $2.10-$7.10. I put in a small limit order at $2.75 (given the spread here, I probably have less of a chance of getting a fill on this limit order than on the previous one).

1One idea we're considering as a future enhancement to Portfolio Armor is to extend the algorithm to cover call hedges on short equity positions.

Disclosure: I have limit orders in to purchase $8 strike, December 2011 puts on DCTH, and $30 strike, December 2011 calls on OMI.

Source: A Pair of Medical Device Options Bets