Wolverine: Another options question (no BJ)

[Wolverine]

Don,
Another investment observation/question for you.

In my humble opinion, the Ag stocks have been severely overbought, and rather than use an outright short position and get killed as "irrational exuberence" continues ad infinitum, I thought I would look at what buying a PUT against the king of the irrational stocks would cost: POTash, Dec 2008 200 puts to be exact.

I have not looked at data from today's trades (just got home), but from Monday's action, the stock closed at 208.79 and the Dec 2008 200 puts were selling for about $31 a share. Using the calculators designed for options, the current pricing puts the volatility % to be about 75%!!!! Since the $VIX (or .vix, depending upon your data provider's preference--the CBOE volatility index) was listed as 20.50 on Monday night, the POT puts were selling at a 3.5x + multiple to the market.

What, if anything, can be said about this situation and what can be done to exploit this market disconnect from reality????? OR is it a disconnect at all? Obviously these stocks (and POT in particular) have gone parabolic/exponential, and someone that can "call the top" is going to make a fortune on the way back down!

Thanks in advance for pondering this novice's investment question. I look forward to your enlightening response.

[Don Schlesinger]

> Don,

> Another investment observation/question for you.

> In my humble opinion, the Ag stocks have been severely
> overbought, and rather than use an outright short
> position and get killed as "irrational
> exuberance" continues ad infinitum, I thought I
> would look at what buying a PUT against the king of
> the irrational stocks would cost: POTash, Dec 2008 200
> puts to be exact.

VERY expensive, no doubt.

> I have not looked at data from today's trades (just
> got home), but from Monday's action, the stock closed
> at 208.79 and the Dec 2008 200 puts were selling for
> about $31 a share. Using the calculators designed for
> options, the current pricing puts the volatility % to
> be about 75%!!!! Since the $VIX (or .vix, depending
> upon your data provider's preference--the CBOE
> volatility index) was listed as 20.50 on Monday night,
> the POT puts were selling at a 3.5x + multiple to the
> market.

As I said! ;-)

> What, if anything, can be said about this situation
> and what can be done to exploit this market disconnect
> from reality?????

Not much. Individual stocks almost always display higher volatilities than an index, or basket, of many stocks. While a single stock may display extreme volatility for quite a while, an index is much less likely to do so, since it comprises so many different stocks that often go in opposite directions, thereby calming volatility.

Suppose your "index" had only two stocks, A and B. Suppose A was very volatile to the upside, while B was equally volatile, to the downside, such that their movements exactly canceled each other out, and the "index," therefore, remained unchanged. The result would be no "volatility" for the index, while its two components were being extremely volatile, on their own.

Clear?

>OR is it a disconnect at all?

See above.

> Obviously these stocks (and POT in particular) have
> gone parabolic/exponential, and someone that can
> "call the top" is going to make a fortune on
> the way back down!

No different for this situation than a million others. All you need is a great crystal ball. :-)

> Thanks in advance for pondering this novice's
> investment question. I look forward to your
> enlightening response.

Don't know how enlightening it was, but what you have to realize is that when stocks are very volatile, everyone wants to buy options on them, to capture the leveraged price movement of the option, if the volatility continues. It doesn't matter if it's calls or puts, up or down, you will have to pay through the nose to own the options.

No free lunch!

Don

[Wolverine]

> Don't know how enlightening it was, but what you have
> to realize is that when stocks are very volatile,
> everyone wants to buy options on them, to capture the
> leveraged price movement of the option, if the
> volatility continues. It doesn't matter if it's calls
> or puts, up or down, you will have to pay through the
> nose to own the options.

> No free lunch!

> Don

Thank you, Don.

I guess my thoughts are: if the options are expensive to "own," shouldn't a person be a seller with that large of a premium?

I would think the best way to accomplish this would be to sell BOTH a similarly strike priced PUT and CALL in the nearest expiration to bank the premiums, hoping ONE expires worthless and the OTHER nearly worthless? As long as the price remains within the strike price +/- the premium banked, you'll break even or make a profit. Of course, getting outside that bracket described to either end will start costing you $. It would be a bet that the options volatility (and therefore premium) is overdone. The options graph would look like an upsidedown "V" with max profit at the strike price, and declining in each direction until the premium is lost, and declining further to indicate potential losses?

I have no intention of doing anything with this information, other than to learn, so please don't worry about me being silly. Thanks.

[Don Schlesinger]

> Thank you, Don.

> I guess my thoughts are: if the options are expensive
> to "own," shouldn't a person be a seller
> with that large of a premium?

I sold options every day for over ten years, so you don't have to convince me. But, you have to have deep pockets to sell options. The risk-reward profile is very different from that of the buyer, who can't lose more than the premium paid.

> I would think the best way to accomplish this would be
> to sell BOTH a similarly strike priced PUT and CALL in
> the nearest expiration to bank the premiums, hoping
> ONE expires worthless and the OTHER nearly worthless?

That's called a short straddle. You can sell those or strangles, where the strike prices are both out-of-the-money. The principle is the same. But, with volatile stocks, the ride to expiration can be very bumpy, and you have to have strong stomach.

> As long as the [stock] price remains within the strike >price
> +/- the premium banked, you'll break even or make a
> profit.

At expiration. The question is whether you'll have the stomach to watch the position go against you PRIOR to expiration, where the marks can be gruesome, and the temptation to bail out very strong. Not unlike BJ, when you lose huge amounts, even while having the edge.

> Of course, getting outside that bracket
> described to either end will start costing you $. It
> would be a bet that the options volatility (and
> therefore premium) is overdone.

It doesn't always work that way. The volatility might drop considerably, and yet you could still lose money if the stock goes unrelentingly in one direction, even as volatility abates. A stock that goes up one percent a day all year has ZERO volatility, and yet, such movement can kill you if you're short a straddle.

Conversely, you could have very high volatility and big movements, only to have the stock close at expiration right at the price it was when you sold the straddle (near the strikes). But, will you be able to sit and watch and do nothing while the stock is moving back and forth?

> The options graph
> would look like an upsidedown "V" with max
> profit at the strike price,

Again, at expiration. While you're trading it, it's an upside down U (curved), and you have to hedge it on an ongoing basis. Each time you do, you lock in a loss, which eats away at the premium that you sold upfront. Over-trade, and you give away a lot of the potential profit. Again, it's not for the faint of heart.

> and declining in each
> direction until the premium is lost, and declining
> further to indicate potential losses?

Infinite losses!

> I have no intention of doing anything with this
> information, other than to learn, so please don't
> worry about me being silly. Thanks.

You've made a good start. The graphs of every position I traded for ten years looked more or less like the one you're describing.

Don

[Wolverine]

Thanks Don, as usual.

Ability to maintain one's calm is obviously a gift and controlling one's actions is absolutely necessary to make a profit in a trading environment (as you well know).

However, am I mistakin in believing that someone else's (the buyer of said options contracts we are discussing) self preservation and desire for THEIR positive financial gain can also get in the way? The option that was sold can be exercised at any time by the buyer, right? Expiration may be June 21st, but on May 29th the conditions of the price and option strike present an opportunity for the buyer to make $5 a share and decides to exercise the option. So, controlling yourself is one thing, but you can't control the counterparty, can you?

Thanks for the education....and clear descriptions. As I said before, you are a master at explaining the difficult.

[Don Schlesinger]

> Thanks Don, as usual.

> Ability to maintain one's calm is obviously a gift and
> controlling one's actions is absolutely necessary to
> make a profit in a trading environment (as you well
> know).

> However, am I mistaken in believing that someone
> else's (the buyer of said options contracts we are
> discussing) self preservation and desire for THEIR
> positive financial gain can also get in the way? The
> option that was sold can be exercised at any time by
> the buyer, right?

Yes, but usually not the case, until close to expiration and only if there is a dividend involved. And, once again, if you sell strangles on indices, rather than individual stocks, the options are almost always European-style exercise and, therefore, can't be exercised early.

> Expiration may be June 21st, but on
> May 29th the conditions of the price and option strike
> present an opportunity for the buyer to make $5 a
> share and decides to exercise the option. So,
> controlling yourself is one thing, but you can't
> control the counterparty, can you?

See above. With a month to go, options usually have some time premium left, unless deep in the money, in which case you probably wouldn't be in your original short position anyway. So, buyers don't normally exercise, when they can simply sell the option and get more than intrinsic value for it (which is all you can get by exercising).

> Thanks for the education....and clear descriptions.

My pleasure.

> As I said before, you are a master at explaining the
> difficult.

Thank you.

Don

[espy3475]

I am not a stock market guru, but looking back to 2000, my observation is that market tops are littered with those trying to short the top. It seems to me, when large short positions build that top can be a long way off. With the current volatility and the slight pullback this week in ag, why not buy the stock and sell call options against the purchase. Let the call take you out. On a pull back, do it again. When the top occurs, you will get your head handed to you on the stock. But you could make enough on the upside on the previous trades to turn a good profit.

What do you guys think?

espy3475

> Don,
> Another investment observation/question for you.

> In my humble opinion, the Ag stocks have been severely
> overbought, and rather than use an outright short
> position and get killed as "irrational
> exuberence" continues ad infinitum, I thought I
> would look at what buying a PUT against the king of
> the irrational stocks would cost: POTash, Dec 2008 200
> puts to be exact.

> I have not looked at data from today's trades (just
> got home), but from Monday's action, the stock closed
> at 208.79 and the Dec 2008 200 puts were selling for
> about $31 a share. Using the calculators designed for
> options, the current pricing puts the volatility % to
> be about 75%!!!! Since the $VIX (or .vix, depending
> upon your data provider's preference--the CBOE
> volatility index) was listed as 20.50 on Monday night,
> the POT puts were selling at a 3.5x + multiple to the
> market.

> What, if anything, can be said about this situation
> and what can be done to exploit this market disconnect
> from reality????? OR is it a disconnect at all?
> Obviously these stocks (and POT in particular) have
> gone parabolic/exponential, and someone that can
> "call the top" is going to make a fortune on
> the way back down!

> Thanks in advance for pondering this novice's
> investment question. I look forward to your
> enlightening response.

[Don Schlesinger]

> I am not a stock market guru, but looking back to
> 2000, my observation is that market tops are littered
> with those trying to short the top. It seems to me,
> when large short positions build that top can be a
> long way off. With the current volatility and the
> slight pullback this week in ag, why not buy the stock
> and sell call options against the purchase. Let the
> call take you out. On a pull back, do it again. When
> the top occurs, you will get your head handed to you
> on the stock. But you could make enough on the upside
> on the previous trades to turn a good profit.

> What do you guys think?

I think that when you are afraid that a stock has made a top and that the impending descent is going to be rapid and steep, selling a naked put (which is what a buy-write is) is a rather risky and poor idea.

Don

[Wolverine]

As a reader of IBD, I stay in touch with the HOT growth stocks. Their philosophy is to identify momentum stocks, and they espouse a sell after a few heavy volume down days to protect the profits made. I was looking for the Wed/Thur action in POT to be that heavy volume sell off (aka, TOP) that gets the stock to roll over.

However, watching Friday's action closely, I noticed that many multi-million dollar purchases were made all the way to the end of the day (from 194 to 207). I'll be watching closely as it approaches the old highs and see how it reacts.

I was actually contemplating the opposite approach: short the stock and buy a call. Mid-day Friday the June 200 calls were $20 (they've gone up since then). Obviously, that means I am looking for a >10% crash in the stock before I can even start making money (by June, no less). I haven't looked into other calls (longer term) yet.

Unfortunately, with this strategy there is no protection from the mob driving it higher. But, when earnings forcasts are being raised 100% by giddy Wall Street analysts, I get the feeling that I've seen the beginning of the end.

I love bubbles: while I didn't jump in on the fertilizers on the way up, I'd like to capitalize on the way down.

By the way, I called the "bottom" in 2-year T-bills, but since the only way to make money there is to short futures (and I don't trade futures, and barely trade options), I didn't have a way to make money.

[Don Schlesinger]

> I was actually contemplating the opposite approach:
> short the stock and buy a call. Mid-day Friday the
> June 200 calls were $20 (they've gone up since then).
> Obviously, that means I am looking for a >10% crash
> in the stock before I can even start making money (by
> June, no less). I haven't looked into other calls
> (longer term) yet.

Why would you bother with a short sell and a call, when you could just go out and buy the put? Same thing, and much simpler.

> Unfortunately, with this strategy there is no
> protection from the mob driving it higher. But, when
> earnings forecasts are being raised 100% by giddy Wall
> Street analysts, I get the feeling that I've seen the
> beginning of the end.

So, buy the put.

> I love bubbles: while I didn't jump in on the
> fertilizers on the way up, I'd like to capitalize on
> the way down.

So, buy the put! :-)

Good luck!

Don

[Wolverine]

Thanks....

[anon]

gentlemen

great to be back on the best 21 page in the universe

interesting this topic should lead as it is one i have thought about extensively.

somewhere in this thread "there is no free lunch" was mentioned and i could not agree more

because i have never been able to outguess market direction i am an efficient market theorist, now i do believe some people have this gift but i know many many professionals and few who can beat the direction game

in this case you are trying to outguess several highly liquid markets, currency, commodities and equities combined.
by shorting these stocks you are betting that the dollar will go up, that the huge pressures to use grains for fuel etc (causing food riots in several places), and the equity market in digesting the profitability of turning grains into money.

formidable indeed

now if we add the idea that options markets are made wide enough for people like me to make a decent living, wide enough to make crossing the bid/ask spread in the underlying stock surmountable, daunting

finally uncle sam as a partner jacking your wins

well

playing 21 you have a quantifiable advantage

betting on naked options one way or the other, in this group especially certainly you have a lot of negative ev to overcome and imho very hard to at least statistically verify your posative ev

[Wolverine]

Great post and I couldn't agree more, hence my substantial trepidation in wading into the shark infested waters of options trading.

However, mobs and mahem have a way of being played, and that is just what I am trying to do. And I also subscribe to the theory: bulls and bears make money, hogs get slaughtered.

I was just looking at the ripe overbought situation and trying to find a way to play the inevitable drop that ALL overbought situations develop into.

An update for those following this boring thread:

After Don told me to sh*t or get off the pot, I bought some $200 POT puts for June at $18.80. Today's close: $27 and change. Nearly 50% made, 48 hours later. If I had done this on Friday, I could have gotten that put at under $16 easily. Thanks for the push Don, I needed it to wade into the water.

I had built an average short position day trading on Friday in POT at $202.25, but cashed out at $205.75 for a $3k loss. If I had stayed in, I would be up $20k today and taking some profits!!!!

Blind luck, or insight? I'm not sure yet, but I've seen too many of these situations develop to NOT enjoy playing with them. And with a resource like Don on the gratis payroll, why not?!? Thanks Don. :-)