Check Your Options Before You Put On A Trade

06/10/10 09:55:26 AM

by Donald W. Pendergast, Jr.

Buying at-the-money puts with favorable vega to theta ratios can make sense, but only in certain circumstances.

Security: IWM
Position: Sell

If you tend to devote substantial amounts of time reading and studying topics related to the financial markets, then you're probably already aware of the recently renewed interest among retail stock and futures traders in selling options rather than buying them. Selling options can put the power of time decay, high implied volatility, and market movement (or even the lack of it) to work for you in unique ways. Then again, buying fairly priced puts and calls can also help add profits to your portfolio when selected with care. Here's a look at two real-life equity market put purchases that will hopefully turn a profit if the broad markets continue to disintegrate.

FIGURE 1: IWM, DAILY. As measures of market internal strength continue to weaken, an IWM August 2010 $62 put purchase becomes attractive to those traders who believe that the February 2010 low near $58 will be reached sooner rather than later.

Graphic provided by: Prophet Financial, Inc.

Graphic provided by: Prophet chart from Thinkorswim platform.

Buying puts with two to three months of time value can be an excellent way to deploy your risk capital, but only if the following market conditions exist:

1. You have strong technical/fundamental reasons to believe that a major bearish market move is imminent.
2. The puts you wish to buy have more than enough time value remaining to capture the bulk of the anticipated move.
3. The puts are trading at reasonable price levels, preferably with a vega to theta ratio of 2 to 1 or better, thus allowing put buyers to capitalize on likely spikes in implied volatility levels that will greatly offset the daily time decay rate of the put.

Here's the first put just purchased, an August 2010 IWM $62 put, net cost of $4.30. That's a $432.90 cash outlay, including commission, at Thinkorswim. Notice the daily candle chart for IWM (Figure 1); you're aware of the major support that exists at the February 2010 swing low of $57.86. That's about $4.07 below today's IWM close of $61.93, and if my belief that IWM is destined to easily reach that price support level well before the August $62 put expires on August 20, 2010, is proved correct, then I stand to garner a favorable return when selling the put for a profit somewhere near the $58.00 per share price level in IWM.

On Wednesday, June 9, 2010, IWM managed to make it high enough to complete a resistance test of its 200-day exponential moving average (EMA) before collapsing like a house of cards during the afternoon session. My take on this is simple — this bear market is a done deal in the Russell 2000, and IWM, as the primary exchange traded fund (ETF) trading instrument of choice for this key small-cap stock index is set for a sustained period of price weakness. With the failed retest of the 200-day EMA, the line of least resistance is down, probably down to the February 5, 2010, low at $57.86, meaning that the August $62 put purchase (bought midway through Wedneday afternoon's decline) has an excellent chance at delivering a couple hundred dollars worth of profit over the next month or so.

FIGURE 2: DELTA. August 2010 IWM $62 put has close to the money delta of (-0.47), low theta of (-0.03), high vega of 0.11, and gamma of 0.04. The big idea with this long put is to capitalize on a steady and/or swift decline in IWM toward that $58 support level in IWM.

Graphic provided by: Thinkorswim.

Figure 2, note the key option Greeks for the IWM August $62 put:

1. The delta is essentially at-the-money (ATM) at (-0.47). This means that if IWM drops say, $0.60 tomorrow, today's closing put price (bid price) of $4.36 will be bumped up by approximately ($0.60 * 0.47), which equals about $0.28, or $4.54. If implied volatility increases at the same time (very probable when a market falls in a bear market), the option should also pick up extra worth as demand for the put option increases (fear being one of the reason for the predictable spike in put values during nasty selloffs).

2. Time decay (theta) is very modest at only $3 per day ($0.03).

3. Even better, the implied volatility (IV) risk (vega) is nearly four times the theta factor, coming in at a whopping $0.11, or $11. What this means is that a sudden (or steady) increase in implied volatility will have nearly four times the impact on this $62 put option's value than daily time decay will — a huge plus for bears who are expecting a swift and sudden drop down toward the February lows in this particular market.

For example, say that implied volatility rises from its current value of 39.18% to 41.22% in one day. That's a 2.04-point increase in IV, which means that the option will gain about $0.22 just from the jump in IV. And even though the option will still lose a bit of value from time decay ($0.03), when you subtract $0.03 from $0.22, you're still up by $0.19 or $19 on the price of your long put.

4. The gamma simply tells us how much the option will increase (decrease) in value for every $1.00 in price movement for IWM. For example, if IWM rises by $0.25 per share tomorrow, multiplying $1.00 by 0.25 gives us 0.25, which we then multiply by the gamma factor of 0.03. The result is 0.0075, meaning that the delta factor of 0.47 will fall to approximately 0.4625 (with puts, deltas fall as underlying prices rise and vice versa). Essentially, for this trade, gamma isn't all that critical. The massively lopsided vega to theta ratio is the real attraction for this particular put purchase.

Managing the trade is very simple, and here's how I will do it. If IWM suddenly manages to close above the 200-day EMA (or Wednesday's high of $63.42), I will close the trade out for a modest loss and then reevaluate my market analysis. However, if we continue lower in IWM and all of the other technicals I monitor (such as short- and long-term money flow, both of which are now in bear territory) continue to deteriorate, then I plan on holding this long August $62 put down to at least the $58 area, which will likely provide IWM with an opportunity to bounce higher. For an idea of the profit potential, here are a few scenarios:

IWM at $58 on June 28, 2010, with IV increase of 4 points

Net profit: $200

IWM at $58 on July 16, 2010, with IV increase of 1.30 points

Net profit: $117

Now for a worst-case scenario:

IWM at $63.60 on June 28, 2010, with IV increase of 5 points

Net loss: (-$80)

Of course, neither I nor anyone else knows how this trade will turn out, but we can say with a degree of conviction that the probabilities are favorable for the trade, especially given the very weak stature of all the broad market indexes right now. I will update this trade in a future article at the time of a final closeout, win or lose. It should be fascinating to see how all of this plays out over the next few weeks!

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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Check Your Options Before You Put On A Trade

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