Q: Counterparty risk on put options?

[stockstradr]

I’m a total amateur at selecting options, so my methods are probably worthless, but here is what I do…

First, I don’t even think about options unless there is out-of-normal (variation) market fluctuation that I am VERY CERTAIN is coming, AND others haven’t priced that in yet. For example, the S&P500 is peaking at 1500, yet the housing market is collapsing, so I expect the stock market will fall dramatically.

Then…
1) I write down my hypothesis, such as, “The S&P500 will fall at least 10% in the next twelve months”
2) I look up the prices of options with expiration dates far beyond the time frame within which I think the market event will occur. (In anticipating market events, we are often biased to expect they will happen MUCH SOONER than they actually happen – we are biased by our wishful thinking! Just ask Rich and I when we originally guessed the home builder stocks would collapse!)
3) I pull down all the current pricing of a type of option, across a wide band of strike prices, and dump them into my Excel spreadsheet. Often there may be 100 rows of various options (for example, all PUTS on the S&P500 that expire 12 to 36 months out.)
4) Using steps in my hypothesis (Market drops 10%, 15% and 20%), the columns in the spreadsheet calculate: A) % return on investment; B) % market drop required to reach break-even on purchase of a particular option; C) actual net profit on one contract

Using that data, my spreadsheet plots curves of % ROI as a function of strike price, plotting separate curves for each step of my hypotheses (For example, -10%, -15%, -20% market move of S&P500)

I also plot break even point (expressed as the min % of market move required to reach break even on a particular option) against strike price.

The curves are most important: I chose options by looking over those curves. Understand, each chart with curves is for options with the same exp date, but I may create several similar charts to compare curves for different expiration dates.

I usually end up buying the options that break even after a very small fraction (as little as 3% to 5%) of my anticipated market move…and also are close to the MAXIMA of my lower %ROI curve, plotted for the conservative value of the correction (in this case 10%) that I expect.

Of course, this kind of analysis will typically steer you away from those dirt cheap out-of-the-money options…to options that inevitably have much higher nominal prices because they are in or near to in the money. I’ll typically buy options that might be $5, $10, or more each. So you’re talking maybe $5,000 for 10 contracts. So this is a safer way but requires larger amounts of money, compared to gambling say $500 on $0.50 out-of-the money options.

You see the reason I don’t chose the $0.50 options that maybe maximize the ROI for a much larger market perturbation (such as a 20% fall in the S&P500) is that the break even point on those options will require a market perturbation that is much less likely (such as a 10% or even 20% move in the underlying security)

People think options are risky, and yes they are. But consider that I bought PUTS on the S&P500 back in Oct ’07 when the S&P500 was over 1500….and yet those options had a break even that only required a ~3% drop in the S&P500!

Were those particular options THAT risky, given market and the unfolding economic conditions? I don’t think so. That’s why I spent 7% of my entire portfolio buying them.

[vegasrenter]

[quote=stockstradr]
First, I don’t even think about options unless there is out-of-normal (variation) market fluctuation that I am VERY CERTAIN is coming, AND others haven’t priced that in yet. For example, the S&P500 is peaking at 1500, yet the housing market is collapsing, so I expect the stock market will fall dramatically.
[/quote]

That’s the goal, but I’ve been SURE and WRONG too many times to rely on this principle.

[quote=stockstradr]
I usually end up buying the options that break even after a very small fraction (as little as 3% to 5%) of my anticipated market move…and also are close to the MAXIMA of my lower %ROI curve, plotted for the conservative value of the correction (in this case 10%) that I expect.
[/quote]

I would like to try your spreadsheet, as this is what I try to do mentally, and it’s too much to keep track of.

Picking options that break even on a small favorable move in the underlying security is dead easy; the further in the money, and the closer to expiration the option is, the smaller the required move to break even. Of course, your return on the move also reduces the further you go that direction, and you lose your shirt (much larger cost per position) if the trade goes against you.

What I end up doing is sitting tight for months on end until the VIX hits the low end of its range, then looking for at-the-money long term puts that are cheap compared to those on similar underlying securities.

Sadly, my GS puts got hammered by the short-covering rally the last 2 days. Good thing they are in the money and have a year left, maybe good things will still happen. These are the kind of days where I’m so glad that I never sell short. Talk about SURE and WRONG, here I am again.

[vegasrenter]

[quote=stockstradr]
First, I don’t even think about options unless there is out-of-normal (variation) market fluctuation that I am VERY CERTAIN is coming, AND others haven’t priced that in yet. For example, the S&P500 is peaking at 1500, yet the housing market is collapsing, so I expect the stock market will fall dramatically.
[/quote]

That’s the goal, but I’ve been SURE and WRONG too many times to rely on this principle.

[quote=stockstradr]
I usually end up buying the options that break even after a very small fraction (as little as 3% to 5%) of my anticipated market move…and also are close to the MAXIMA of my lower %ROI curve, plotted for the conservative value of the correction (in this case 10%) that I expect.
[/quote]

I would like to try your spreadsheet, as this is what I try to do mentally, and it’s too much to keep track of.

Picking options that break even on a small favorable move in the underlying security is dead easy; the further in the money, and the closer to expiration the option is, the smaller the required move to break even. Of course, your return on the move also reduces the further you go that direction, and you lose your shirt (much larger cost per position) if the trade goes against you.

What I end up doing is sitting tight for months on end until the VIX hits the low end of its range, then looking for at-the-money long term puts that are cheap compared to those on similar underlying securities.

Sadly, my GS puts got hammered by the short-covering rally the last 2 days. Good thing they are in the money and have a year left, maybe good things will still happen. These are the kind of days where I’m so glad that I never sell short. Talk about SURE and WRONG, here I am again.

[vegasrenter]

[quote=stockstradr]
First, I don’t even think about options unless there is out-of-normal (variation) market fluctuation that I am VERY CERTAIN is coming, AND others haven’t priced that in yet. For example, the S&P500 is peaking at 1500, yet the housing market is collapsing, so I expect the stock market will fall dramatically.
[/quote]

That’s the goal, but I’ve been SURE and WRONG too many times to rely on this principle.

[quote=stockstradr]
I usually end up buying the options that break even after a very small fraction (as little as 3% to 5%) of my anticipated market move…and also are close to the MAXIMA of my lower %ROI curve, plotted for the conservative value of the correction (in this case 10%) that I expect.
[/quote]

I would like to try your spreadsheet, as this is what I try to do mentally, and it’s too much to keep track of.

Picking options that break even on a small favorable move in the underlying security is dead easy; the further in the money, and the closer to expiration the option is, the smaller the required move to break even. Of course, your return on the move also reduces the further you go that direction, and you lose your shirt (much larger cost per position) if the trade goes against you.

What I end up doing is sitting tight for months on end until the VIX hits the low end of its range, then looking for at-the-money long term puts that are cheap compared to those on similar underlying securities.

Sadly, my GS puts got hammered by the short-covering rally the last 2 days. Good thing they are in the money and have a year left, maybe good things will still happen. These are the kind of days where I’m so glad that I never sell short. Talk about SURE and WRONG, here I am again.

[vegasrenter]

[quote=stockstradr]
First, I don’t even think about options unless there is out-of-normal (variation) market fluctuation that I am VERY CERTAIN is coming, AND others haven’t priced that in yet. For example, the S&P500 is peaking at 1500, yet the housing market is collapsing, so I expect the stock market will fall dramatically.
[/quote]

That’s the goal, but I’ve been SURE and WRONG too many times to rely on this principle.

[quote=stockstradr]
I usually end up buying the options that break even after a very small fraction (as little as 3% to 5%) of my anticipated market move…and also are close to the MAXIMA of my lower %ROI curve, plotted for the conservative value of the correction (in this case 10%) that I expect.
[/quote]

I would like to try your spreadsheet, as this is what I try to do mentally, and it’s too much to keep track of.

Picking options that break even on a small favorable move in the underlying security is dead easy; the further in the money, and the closer to expiration the option is, the smaller the required move to break even. Of course, your return on the move also reduces the further you go that direction, and you lose your shirt (much larger cost per position) if the trade goes against you.

What I end up doing is sitting tight for months on end until the VIX hits the low end of its range, then looking for at-the-money long term puts that are cheap compared to those on similar underlying securities.

Sadly, my GS puts got hammered by the short-covering rally the last 2 days. Good thing they are in the money and have a year left, maybe good things will still happen. These are the kind of days where I’m so glad that I never sell short. Talk about SURE and WRONG, here I am again.

[vegasrenter]

[quote=stockstradr]
First, I don’t even think about options unless there is out-of-normal (variation) market fluctuation that I am VERY CERTAIN is coming, AND others haven’t priced that in yet. For example, the S&P500 is peaking at 1500, yet the housing market is collapsing, so I expect the stock market will fall dramatically.
[/quote]

That’s the goal, but I’ve been SURE and WRONG too many times to rely on this principle.

[quote=stockstradr]
I usually end up buying the options that break even after a very small fraction (as little as 3% to 5%) of my anticipated market move…and also are close to the MAXIMA of my lower %ROI curve, plotted for the conservative value of the correction (in this case 10%) that I expect.
[/quote]

I would like to try your spreadsheet, as this is what I try to do mentally, and it’s too much to keep track of.

Picking options that break even on a small favorable move in the underlying security is dead easy; the further in the money, and the closer to expiration the option is, the smaller the required move to break even. Of course, your return on the move also reduces the further you go that direction, and you lose your shirt (much larger cost per position) if the trade goes against you.

What I end up doing is sitting tight for months on end until the VIX hits the low end of its range, then looking for at-the-money long term puts that are cheap compared to those on similar underlying securities.

Sadly, my GS puts got hammered by the short-covering rally the last 2 days. Good thing they are in the money and have a year left, maybe good things will still happen. These are the kind of days where I’m so glad that I never sell short. Talk about SURE and WRONG, here I am again.

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