Speculative Option Buy Update

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Last week, I mentioned that with volatility near two year lows, I'd been spending some time looking for speculative option buys. I noted that I'd been looking to place bullish and bearish bets, so I’d have a better shot at making some money whatever direction the market takes in the next several months.

As I mentioned last week, while doing this, I’ve been keeping in mind a few points Tim 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)

I noted also that in addition to Tim's three guidelines, I'd added a fourth:

  • buy options at a discount to model estimates of their fair market value.

A quick recap on my M.O. with this: for the bearish bets, I’ve been starting by scanning for relatively lightly-traded (average daily volume over the last month of 150k-200k 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 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.

I mentioned Thursday that I had placed limit orders for in-the-money calls on these five stocks: AEG, SVN, SUP, ASMI, and COHR.

And limit orders for in-the-money puts on these five stocks: CPIX, LOJN, HIL, PNCL, and MDS.

Unfortunately, I went 0-for-10 on those limit orders Thursday, but I repriced the options Thursday night, and put in small limit orders for options on 8 of those stocks for Friday. I didn't see the confirm until Monday, but it turns out I got a fill on my small limit order for calls on COHR. Checking the Black-Scholes value of those options now, and their bid-ask spread as of Monday, it looks like it may be possible to buy more of them Tuesday at a discount to their Black-Scholes fair market value estimate. More on that below, but first a quick reminder about the difference between speculative options buying and hedging.

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 a directional bet in the case below, though, and not hedging, I placed a limit order on 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

Cohere, Inc. (NASDAQ: COHR), headquartered in Silicon Valley, manufactures lasers and precision optics.

Short Screen shows an Altman Z-Score of 6.48 for COHR (scores above 3 indicate financial strength according to the model).

Audit Integrity rates COHR as having “conservative” Accounting & Governance Risk (AGR®), placing it in the 92nd percentile (i.e., it has higher accounting & governance risk than 8% of the 8,000 companies Audit Integrity rates). 

COHR closed at $61.96. The bid-ask spread on the November, $60 strike calls on COHR was $6.90-$8.00 as of Monday. The Black-Scholes  estimate of the fair market value of those calls as of Monday's close was $8.78.

One caution: COHR's earnings call is scheduled for Tuesday after the close.