In an article earlier this month, I mentioned a few guidelines I'd been keeping in mind when making speculative options buys:
- Start small (since options often expire worthless).
- Avoid out-of-the-money-options (instead, try to get ones with some intrinsic value).
- Avoid nearby expiration dates (to avoid theta burn and give positions more time to work out).
- Buy options at a discount to model estimates of their fair market value.
I've been making occasional bullish and bearish bets to increase the chances that some bets will make money whatever direction the market takes over the next several months. I've also been trying to take advantage of relatively low volatility when buying options.
On Tuesday night I placed limit orders for a few bullish and bearish bets. I've highlighted two of them below, but first a recap of my modus operandi here, and a reminder about the difference between speculative options buying and hedging.
Looking for Speculative Options Bets
For the bearish bets, I’ve been starting by scanning for relatively lightly-traded (average daily volume over the last month of 150k-250k shares or less), optionable stocks that look weak technically and fundamentally. The idea behind looking for relatively thinly-traded stocks is that the options traded on them are more likely to be thinly-traded, which increases the chances that they might be inefficiently priced. Then I look for in-the-money puts on them several months out, and compare the current bid-ask prices for them with the estimated fair market value of them via the Black-Scholes model.
If I find one where the most recent bid is significantly below the Black-Scholes fair market value estimate, I’ll place a small limit order for it, with the limit price set at a ~20%+ discount to the fair market value estimate.
For the bullish bets, I’ve been doing the reverse: Scanning for stocks that look strong technically and fundamentally, and looking for in-the-money calls priced below the Black-Scholes estimates of their fair market value.
Prior to Tuesday, I used this method to purchase puts on The St. Joe Company (JOE), Northern Dynasty Minerals, Ltd. (NAK), Motricity, Inc. (MOTR), Neutral Tandem Inc. (TNDM); and calls on Honda Motor Co Ltd. (HMC), Hitachi, Ltd. (HIT), and Coherent, Inc. (COHR). I noted these purchases at the time on the Short Screen message boards.
Hedging vs. 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 “shares owned” 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 presented might be in-the-money; in most cases however they will be out-of-the-money. Since I’m making a directional bet in the cases below, though, and not hedging, I bought slightly in-the-money options. 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).
A Bullish Bet
IIVI Incorporated (IIVI) manufactures precision optical components for use in lasers - (click charts to expand).
Zacks Investment Research ranks IIVI Incorporated (IIVI) a short term buy.
Audit Integrity gives it an "average" Accounting & Governance Risk (AGR®) score.
IIVI closed at $54.32 Tuesday. As of Tuesday's close the estimated fair market value of its $50 strike, October 2011 calls, according to the Black-Scholes model, was $10.23. I placed a limit order to buy them at $8.10.
A Bearish Bet
Pulse Electronics Corporation (PULS) manufactures electronic components such as power inductors, converters and transformers.
Zacks Investment Research ranks Pulse Electronics Corporation (PULS) a short term sell.
Audit Integrity gives it an "aggressive" Accounting & Governance Risk (AGR®) score.
PULS closed at $4.80 on Tuesday. As of Tuesday's close the estimated fair market value of its $5 strike, October 2011 puts, according to the Black-Scholes model, was $0.53. I placed a limit order to buy them at $0.40.
Disclosure: I am long puts on JOE, NAK,and TNDM, and long calls on COHR. I have limit orders in to buy puts on PULS and calls on IIVI.