- 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.
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 shares), optionable stocks that look weak technically and fundamentally. The reason I look 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 Thursday, I used this method to purchase puts on The St. Joe Company (NYSE:JOE), Northern Dynasty Minerals Ltd. (NAK), Motricity Inc. (MOTR), Neutral Tandem Inc. (NASDAQ:TNDM), Midas Group Inc. (MDS), BioCryst Pharmaceuticals (NASDAQ:BCRX), Omeros Corporation (NASDAQ:OMER), Citi Trends Inc. (NASDAQ:CTRN); and calls on Honda Motor Co. Ltd. (NYSE:HMC), Hitachi Ltd. (HIT), Coherent Inc. (NASDAQ:COHR), IXYS Corporation (IXYS), II-VI Incorporated (IIVI), ASM International N.V. (ASMI) and Superior Industries International Inc. (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 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). There's a step-by-step example of that in this article.
A Bearish Bet
School Specialty Inc.(SCHS) is provides supplemental educational products and equipment for the pre-kindergarten to twelfth grade market in the United States and Canada.
Short Screen shows an Altman Z"-Score of -2.19 for SCHS (recall that scores of 1.1 and lower indicate financial distress, according to the model).
SCHS closed at $12.81 Thursday. At that price, the estimated fair market value of its $15 strike, February 2012 puts, according to the Black-Scholes model, was $3.72. The bid-ask on those puts was $2.65-$3.50. I put in a limit order for them at $2.95.