- + 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.
On Thursday night I was going through some screens, and came across a stock I'd already bought puts on a couple of weeks ago -- OMER. I had bought the $7.50 strike November puts on it, but it looks like you'd be able to buy the $5 strike November puts on it for a discount to the Black-Scholes estimate of their fair market value today (Friday). More on that below, but first a recap of how I've been looking for these speculative options buys, 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), 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 JOE, NAK, MOTR, TNDM; and calls on HMC, HIT, COHR, SUP, and ASMI. I noted these purchases (and sales, in the case of HMC, HIT, and MOTR) 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 was making a directional bet with OMER, 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).
Omeros Corporation (NASDAQ:OMER) is a clinical-stage biopharmaceutical company. As I've mentioned before, 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.
OMER has a PEG ratio of -0.4 based on analysts' estimates of its (negative, expected) earnings over the next five years.
I picked up the $7.50 strike November puts on OMER a couple of weeks ago, because OMER was trading above $5 and I wanted to get in-the-money puts (there were no strike prices between $5 and $7.50). OMER closed at $4.69 Thursday though, so the $5 strike puts are now in the money.
As of Thursday's close, the Black-Scholes estimate of the fair market value of the $5 strike, November puts on OMER was $1.73. The bid-ask on them now is $0.90 by $1.25, so even the ask is ~27% below yesterday's B-S fair market value estimate.
In a post elsewhere earlier this week ("2 Speculative Options Bets"), I mentioned that I had placed a limit order to buy $50 strike, October calls on IIVI. I didn't get a fill on them then, but I got a fill on the $55 strike October calls today, which were also trading at a significant discount to the Black-Scholes estimate of their fair market value.