In previous posts, I've mentioned a few guidelines I've been keeping in mind when making speculative options buys (the first three of which are mentioned in Tim Knight's book, Chart Your Way to Profits):
- + 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 bullish and bearish bets to increase the chances that some bets will make money whichever direction the market takes over the next several months. I've also been trying to take advantage of relatively low volatility when buying options (though if volatility keeps ticking up, I may start to hold off on making new speculative options buys).
On Tuesday night I placed limit orders for several small bullish and bearish bets. I got a fill on two of them during the day Wednesday, calls on IXYS Corporation (NASDAQ:IXYS) and puts on Omeros Corporation (NASDAQ:OMER). More on those below. 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< 200k-225k shares), 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 today, I used this M.O. to purchase puts on St. Joe (NYSE:JOE), Northern Dynasty Minerals Ltd. (NAK), Motricity Inc. (MOTR), Neutral Tandem Inc. (NASDAQ:TNDM); and calls on HONDA MOTOR CO. LTD. (NYSE:HMC), Hitachi, Ltd. (HIT), Coherent Inc. (NASDAQ:COHR), Superior Industries International Inc. (NYSE:SUP), and ASM International N.V. (ASMI). 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 as a web app 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 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
IXYS Corporation (NASDAQ:IXYS) is a an integrated semiconductor company.
IXYS has a PEG Ratio of 0.29, based on analysts' estimates of its earnings over the next five years.
As of Tuesday's close, the Black-Scholes estimate of the fair market value of IXYS's $15 strike, October calls was $2.23. I bought them for $1.80 Wednesday (the B-S estimate of their fair market value dropped to $1.97 after Wednesday's drop in price of the underlying).
A Bearish Bet
Omeros Corporation (NASDAQ:OMER) is a clinical-stage biopharmaceutical company. These are the kinds of stocks I generally prefer to bet against with puts rather than by shorting them, because they can spike on news of an FDA approval, or a partnership deal with a big pharma company.
Omeros Corporation has a PEG ratio of -0.4 based on analysts' estimates of its (negative, expected) earnings over the next five years.
As of Tuesday's close, the Black-Scholes estimate of the fair market value of the $7.50 strike, November puts on Omeros Corporation was $3.50. I bought them at $2.85 Wednesday (the B-S estimate of their fair market value rose slightly to $3.57 after the drop in the underlying Wednesday).