Slope of Hope Blog Posts

Slope initially began as a blog, so this is where most of the website’s content resides. Here we have tens of thousands of posts dating back over a decade. These are listed in reverse chronological order. Click on any category icon below to see posts tagged with that particular subject, or click on a word in the category cloud on the right side of the screen for more specific choices.

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.

Speculative Options Buys

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Hey fellow Slopers,

With volatility continuing to hover near two-year lows, I’ve been spending more time looking for speculative option buys. I’ve been looking to place bullish and bearish bets, so I’ll have a better shot at making some money whatever direction the market takes in the next several months.

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’ve been following each of those guidelines in my recent speculative options bets, and I’ve added a fourth one to boot:

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

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 25%-30%+ 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.

After the close Wednesday, I placed 10 limit orders (5 for calls, 5 for puts) on options that met all the criteria above — if I’m lucky, I’ll get a fill on a few of them Thursday. More on those below, but first a quick clarification, since I’ve written about options in the context of hedging in recent posts: the trades for which I placed these limit orders are speculative directional bets, not hedges.


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 directional bets in the cases below, though, and not hedging, I placed limit orders on in-the-money options that were close to the current prices of the underlying stocks. 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).

I 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.

To keep this post from getting too long, I’ll just highlight one of each of those orders below.


A Bearish Bet

Pinnacle Airlines Corp. (NASDAQ: PNCL) is a regional airline holding company that was once a top pick of hedge fund manager Mohnish Pabrai (I’m not sure if he still owns it).

According to Short Screen, PNCL has an Altman Z”-Score of 0.55 (Z”-Scores below 1.1 indicate financial distress).

PNCL closed at $5.40 on Wednesday, and the bid-ask on its $7.50 strike, December 2011 puts was $0.20-$4.70.  The Black-Scholes estimate of the fair market value of those puts was $2.32. I put in a small limit order at $1.60.

A Bullish Bet

Superior Industries International, Inc. is an auto parts supplier manufacturing aluminum wheels.

Short Screen shows an Altman Z-Score of 4.77 for SUP. Z-Scores of 3 and higher indicate financial strength (Short Screen automatically applies the five-term Z-Score to SUP, and not the four-term Z”-Score, because SUP is a manufacturing company, unlike PNCL).

SUP closed at $25.34 Wednesday, and the bid-ask spread on its $22.50 strike, October 2011 calls was $3.00-$4.40. The Black-Scholes estimate of the fair market value of those puts was $4.54. I put in a small limit order for them at $3.20.

Hedging Macro Trend Risk

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Hey fellow Slopers,

My largest long position is an Australia-based nano cap I've mentioned in the comments on occasion, Alloy Steel International (Pink Sheets: AYSI). AYSI uses a high tech, proprietary process to manufacture protective wear plates for mining equipment. Essentially, the company is a picks & shovels play on the mining industry (particularly iron ore and coal mining). As such, it has the potential to benefit from the macro trend of Chinese demand for those commodities.

As is typical of nano caps, there are no options traded on AYSI, so it's impossible to use options to hedge against AYSI's idiosyncratic, or stock-specific risk — some of which it has exhibited over the last week, as the stock dropped 25% after reporting a sequential drop in earnings in its fiscal Q1, following its release of record Q4 and annual numbers in February:

The way I try to manage AYSI's idiosyncratic risk is by keeping my cost basis low (e.g., by buying more when the stock tanked to the low .40s last year, and not buying more when it spiked to $1.89 earlier this year, after releasing its 2010 numbers). How to hedge against its macro trend risk though, i.e., a big dropoff in Chinese commodity demand?

One way is to look for an optionable stock that's exposed to the same macro trend risk. BHP Billiton (NYSE: BHP ) fits that bill here (and is also a good fit for another reason: it's one of AYSI's largest customers). If you've got a position in AYSI, you could look at an equivalent dollar amount position in BHP and consider buying optimal puts on it as a hedge against macro trend risk. Using Portfolio Armor (available as a web app and as an Apple iOS app), you could simply enter "BHP" in the symbol field, your dollar-equivalent number of shares in the "shares owned" field, and the maximum decline you're willing to risk in the "threshold" field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost. What number should you use as a maximum decline threshold though? 

In previous posts on hedging, I mentioned that I often use a 20% decline threshold when hedging (i.e., I hedge against a greater-than-20% loss), and that I got that idea from a comment fund manager John Hussman made in a market commentary in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

I wouldn't use a 20% threshold in this case though. If there's a big dropoff in Chinese demand for iron ore, I'd expect a much bigger decline in BHP's share price. How much of a decline? Take a look at the 5 year chart of BHP below. 

The lows of late '08 could be attributed to the general end-of-the-world atmosphere post-Lehman, so I'd start with BHP's share price in Q1 '09. By the end of Q1 '09, some of the immediate panic of the global financial crisis had lifted, but there were still fears about a dropoff in Chinese commodity demand. At its lows in Q1 09, BHP was trading at about 10x its trailing earnings. Currently, it's trading at about 16.5x its trailing earnings (of $6.13). So if BHP's valuation dropped to 10x its trailing earnings today, the stock would be trading at $61.30, about a 40% drop from BHP's closing price Wednesday of $101.16. So I'd use 40% as my threshold if I were looking for optimal puts on BHP as a hedge against the macro trend risk of a dropoff in Chinese iron ore and coal demand.

Checking Portfolio Armor now, the cost of hedging against a >40% drop in BHP over the next seven months, using the optimal puts for that, is 0.86% of your position value. I may pick up a few of those optimal puts this week, while the VIX continues to hover near its two-year lows.

Optimal Puts vs. Index ETFs for Hedging

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Hey Fellow Slopers,

This another post that might be a little basic for some of you, but a question came up recently about the differences between hedging with inverse ETFs and optimal puts, and since I know there are some self-described beginners among Slope lurkers, I thought it would be worth an elaboration here.

Inverse ETFs can be useful tools in hedging against market, sector, or industry risk, but there are a few reasons why investors may want to consider using optimal puts to provide downside protection for their portfolios (a quick reminder: optimal puts are the ones which will give you the exact level of protection you want at the lowest possible cost):

  • Ability to hedge against idiosyncratic (or, stock-specific) risk. Say you own a particular stock and you are unwilling or unable to sell some of your stake in it to reduce your downside risk. If the stock has options traded on it, you may be able to use optimal puts to hedge against a decline due to an event specific to that stock. Inverse ETFs can be used to offset market risk or industry risk, but not stock-specific risk. For example, if you owned Toreador Resources Corp. (TRGL — a stock we mentioned in a post here last month,"Market Neutral: Short TRGL, Long IMO") at the beginning of the year, owning optimal puts on it could have limited your downside as TRGL declined since then, but owning shares of the ProShares Short Oil & Gas ETF (DDG) wouldn't have, as that inverse ETF has declined year-to-date as well, as the chart below shows.  TRGL
  • Precision. Say you own 824 shares of Exxon Mobil, and you'd like to know how to hedge that position against a greater-than-17% loss. Using Portfolio Armor (available as a web app and as an Apple iOS app), you could simply enter "XOM" in the symbol field, "824" in the number of shares field, and "17%" in the threshold field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost.1
  • Ability to cap cost at the outset. It's not always clear how investors who use inverse ETFs decide how much of their portfolios to allocate to them — I've asked Inverse ETF investors about this in the past, and in response have been told they "feel comfortable with" some small percentage. To use a round number here, let's say an investor decided to allocate 10% of his portfolio to an unleveraged, inverse index ETF, such as ProShares Short S&P 500 (SH), to provide him some downside protection against a market correction. What if the S&P 500 went on to stage a rally instead — what if it went up another 25% over the next several months? In that case, the investor's portfolio might be 2.5% lower than it would have been had he not purchased that downside protection. What if, instead, the investor bought the optimal puts to hedge against a greater-than-20% decline in the ETF that tracks the S&P 500, the SPDR S&P 500 (SPY)? As of Wednesday's close, the cost of those optimal puts was 0.86%; if the investor bought enough of those optimal puts to hedge his whole portfolio, their drag on his performance in the event of a 25% market rally would be capped at 0.86%.2

It's worth noting that, in that last case, part of the reason the optimal puts on SPY are so cheap is that volatility is still relatively low. The VIX volatility index closed Wednesday at 15.07, close to its 52-week low of 14.30 (its 52-week high was 48.2). Volatility can spike quite quickly though, so if you are considering hedging, you may want to consider doing so while volatility remains relatively low.

Disclosure: I am short TRGL.

1In that case, Portfolio Armor would round down the number of shares you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with eight of the put option contracts that would slightly over-hedge the 800 shares they cover, so that the total value of your 824 shares would be protected against a greater-than-17% loss.

2For the sake of simplicity there, I ignored the transaction fees of purchasing the ETF and the options, and I ignored the management fee of the ETF.

Textual Intercourse

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This week is only three days old, but it feels like an eternity.

I came into the week 115% committed with a split of about 85/15 between bearish and bullish positions. Monday was a good day (obviously), and it seemed that things were starting to finally crack.

Ha!

The S&P downgrade can now be added to a long, long list of "this time for sure!" events that have been squished like a grape. The Dow is at a new recovery high, and all the after-hours activity is bullish again.

So while Monday was terrific, and Tuesday I gave up just a portion of those profits, Wednesday flat-out stunk. I was only 82% committed, but the portfolio was purely shorts, and I got stopped out left and right. I spent the day endeavoring to even out the portfolio with bullish positions to achieve more of a 50/50 split. The risk of the S&P bolting to 1430 is simply too great, and I don't get my jollies out of being smacked across the face with a ball peen hammer.

Suffice it to say that waking up to an /ES that was 17 points higher was just as unsettling as waking up to an /ES 17 points lower was exhilirating. As I sit here now, I am far more comfortable with a 50/50 portfolio of carefully-selected stocks. I don't have a single general equity ETF (like SPY, DIA, etc.) in either direction.

Of course, the downside of a totally balanced portfolio is that any moves are going to be completely muted. If we soar 150 points up (or down) tomorrow, the best I can hope for is a small profit (intraday ETF trades notwithstanding), since the only thing that prevents the positions from totally cancelling each other out is – – God willing – – that the selections are good enough so that the longs are a little stronger than average and the shorts are a little weaker than average.

But the market seems to be switching direction every couple of days, and I'm not comfortable being totally bullish or totally bearish right now. I am also very, very "light", with a big chunk of the portfolio in cash.

The point is that having such a portfolio coming into Monday (or Wednesday, for that matter) would have greatly reduced my portfolio's volatility. One would love to be totally long on up days and totally short on down days, but as long as you are fantasizing, you might as well imagine Gong Li giving you a vigorous massage with essential oils while you monitor your positions.

At present I've got 27 longs and 24 shorts. That's right – I have more longs than shorts. A few of the longs include CAVM, FNSR, GOOG, MA, MIPS, and VMED, and a few of the shorts include CQP, GS, HRB, NTAP, RADS, UAL, and XRTX.

One final word to those precious metals bulls out there who are setting the world on fire. I know exactly how it feels to be "printing" money just about every day. In the blessed months of late 2008 and early 2009, it seemed like I could do no wrong. Almost everything I did seemed to make money. That must be how you are feeling right about now.

Enjoy it while it lasts. Take those profits and have a treasure bath. But be really mindful of your mindset when it ends. And I know you don't believe me, but it will end someday, and years from now people will marvel at a chart like SLV and wonder what on earth people were thinking. I don't know when the party in precious metals will end, but it's easy to lose sight that markets don't usually throw giant sacks of cash at people like this. You have my fondest hopes of maximizing your profits and making an elegant exit. But take it from someone who knows how it feels to do everything right – – and who also knows how it feels when it seems he does everything wrong – – it ain't gonna last forever, as much as you hope it might.