While doing this, I’ve been keeping in mind a few points Tim Knight made in his book, “Chart Your Way to Profits.” On p. 474, Tim offered a few common sense guidelines about speculative options buying:
- 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 your position more time to work out)
- Buy options at a discount to model estimates of their fair market value.
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 about a 20%-30% 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.
After the close Thursday, I placed 8 limit orders (4 for calls, 4 for puts) on options that met all the criteria above — if I’m lucky, I’ll get a fill on a couple of them Friday. 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 on the web 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 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).
I placed limit orders for in-the-money calls on these four stocks: SVN, SUP, ASMI, and COHR.
And limit orders for in-the-money puts on these five stocks: CPIX, PNCL, CTE and MDS.
To keep this post from getting too long, I’ll just highlight one of each of those orders below.
A Bearish Bet
Pinnacle Airlines Corp. (PNCL) is a regional airline holding company that some here may be familiar with as a holding of hedge fund manager Mohnish Pabrai.
According to Short Screen, Pinnacle has an Altman Z”-Score of 0.55 (Z”-Scores below 1.1 indicate financial distress).
Pinnacle closed at $5.40 on Thursday, and the bid-ask on its $7.50 strike, December 2011 puts was $1.60-$4.80. The Black-Scholes estimate of the fair market value of those puts was $2.31. I put in a small limit order at $1.80.
A Bullish Bet
Superior Industries International Inc. (SUP) is an auto parts supplier manufacturing aluminum wheels.
Short Screen shows an Altman Z-Score of 4.77 for SUP. Z-Scores of 3 and higher indicate financial strength (Short Screen automatically applies the five-term Z-Score to Superior Industries, and not the four-term Z”-Score, because Superior Industries is a manufacturing company, unlike Pinnacle).
Superior Industries closed at $25.19 Thursday, and the bid-ask spread on its $25.00 strike October 2011 calls was $1.90-$2.80. The Black-Scholes estimate of the fair market value of those calls was $3.14. I put in a small limit order for them at $2.30.