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In previous articles, 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. I had held off on looking for new speculative options bets as the Chicago Board Options Exchange Market Volatility Index (VIX) hovered over 20, but after it dropped to 17.27 Wednesday, I decided to look again.

Two Bets for Thursday

After the close Wednesday, I placed small limit orders for one bullish speculative options bet and one bearish one. More on those 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 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 look for in-the-money calls priced below the Black-Scholes estimates of their fair market value.

Examples

Prior to today, I used this method to purchase puts on The St. Joe Company (NYSE:JOE), Northern Dynasty Minerals, Ltd. (NYSEMKT:NAK), Motricity, Inc. (MOTR), Neutral Tandem Inc. (NASDAQ:TNDM), Midas Group, Inc. (NYSE:MDS), BioCryst Pharmaceuticals (NASDAQ:BCRX), Omeros Corporation (NASDAQ:OMER); and calls on Honda Motor Co Ltd. (NYSE:HMC), Hitachi, Ltd. (HIT), Coherent, Inc. (NASDAQ:COHR), IXYS Corporation (NASDAQ:IXYS), II-VI Incorporated (NASDAQ:IIVI), ASM International N.V. (NASDAQ:ASMI) and Superior Industries, International, Inc. (NYSE:SUP). I noted these purchases (and sales, in the case of the ones I've exited already -- NAK, MOTR, HMC and HIT) 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 proprietary 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 by Portfolio Armor 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 Bearish Bet for Thursday

Alliance Healthcare Services, Inc. (NASDAQ:AIQ), headquartered in Newport Beach, CA, provides outpatient diagnostic imaging services and radiation therapy services in the United States.


(Click to enlarge)

VectorVest gives AIQ a "sell" recommendation. On a scale from 0-to-2.00, with 2.00 being the best score, VectorVest rates AIQ a 0.08 for Relative Value, a 0.65 for Relative Safety and a 0.77 for Relative Timing.

AIQ closed at $3.77 Wednesday. At that price, the estimated fair market value of its $5 strike, December 2011 puts, according to the Black-Scholes model, was $1.29. I placed a limit order to buy them Thursday at $1.00.

A Bullish Bet for Thursday

Alliance Resources Partners, L.P. (NASDAQ:ARLP), headquartered in Tulsa, OK, produces coal for American utilities.


(Click to enlarge)

VectorVest gives ARLP a "buy" recommendation. On a scale from 0-to-2.00, with 2.00 being the best score, VectorVest rates AIQ a 1.46 for Relative Value, a 1.36 for Relative Safety and a 1.03 for Relative Timing.

ARLP closed at $77.01 Wednesday. At that price, the estimated fair market value of its $75 strike, December 2011 calls, according to the Black-Scholes model, was $8.22. I placed a limit order to buy them Thursday at $6.10.

Disclosure: I am long puts on JOE, TNDM, MDS, BCRX, OMER and SRDX; and calls on COHR, IXYS, IIVI, ASMI and SUP; and have limit orders in to buy puts on AIQ and calls on ARLP.

Source: A Bullish Speculative Options Bet and a Bearish One