Ask Us Anything

by CC December 21, 2011 12:48 pm • Commentary

Here’s highlights of some of the better questions we’ve received across email or the Twitters with answers from the team. If your question wasn’t featured it’s most likely because it was dumb. (Kidding! There are no dumb questions here, it’s most likely because I couldn’t find it in my progressively more unmanageable email queue. Never be afraid of sounding dumb, we do it everyday.)

 

Someone purchased a Jan 30/35 call spread on RCL 50,000x a few weeks ago. I think they paid .75 for this spread. The cost of this was $3.5 million! It is worth about $1.5 million now. How do you guys feel about situations like this? – MR

I wouldn’t always assume that it is a bullish trade, could be a hedge that a dealer puts on against a big corporate trade or something that traded over the counter……generally I am not a fan of following big blocks as you generally have no idea of the reason for the trade. -Dan

 

What do you think of ALXN and ULTA as put spread candidates? Here’s IDB descriptions of their chart patters which are late stage:

UPDATED 12/15/2011 01:12 PM ET | Ulta Beauty triggered the 8% sell rule Wednesday as it dived 5%, taking it almost 10% below a 74.10 buy point. Ulta had been dancing sideways near the buy point until recently. The market’s environment is proving to be tough. But Ulta’s difficulties may be due mostly to the fact that its latest base was a late-stage pattern. The stock has had a monster run since its March 2009 low. With the latest breakout now a failure, the best hope is for Ulta to form a new pattern that undercuts the low of the previous base

UPDATED 12/16/2011 06:32 PM ET | Alexion Pharmaceuticals is forming a flat base with a 70.52 buy point. The stock on Dec. 16 overcame resistance at its 50-day moving average with a nice volume surge. But Alexion’s up/down volume ratio has slipped to 0.8 from 1.1 just a few weeks ago. Realize, too, that Alexion has had a long advance and has not undercut any bases. – TE

I don’t know anything about either company from the fundamental side but the charts do look interesting. I guess the play that we usually try to do on the site is to isolate some upcoming event or fundamental story that will happen in the near future in a stock and place a structured trade around that. So we usually start with the fundamental side, (this company is overvalued, expectations are too low for this company, etc.) then go to the technical side to figure out the structure and where a stock could move if the herd is wrong. Dan and I aren’t good enough technical analysts to have that lead the decision making. Others do though, certainly. Those stocks do set up well for put spreads, but I think you need to figure out what, if not the broader market, will get them to do an outsized move from what the options are pricing. Remember, option premium is such that you can be right on direction and still lose money if the move happens too slowly. -CC

 

The put fly could be constructed in such a way as to not lose money if there is a swoosh down to let’s say below 22 strike. How about buying 20 instead of 10 22 strike puts or 23 strike puts instead of 22? This would ensure that for a few cents more, you are guaranteed to make some money if the magnitude of favourable move is high, but at the same time lose only a few more cents if the move is not in favorable direction. -AK

You are right that if you don’t buy a symmetric butterfly you are likely to make money in the case of an outsized move. If you bought the dec 26/24/23 put fly for .50 as opposed to .39 that I paid for the 26/24/22. I guess I use flys when I don’t think the stock will have an outsized move though….but I do know traders who do this.

 

What are the option parameters that you use to suggest that you have a good trade. Is it based upon the percentage of money that can be made, the premium vs the stock price, etc? As a recent subscriber, I notice that most of your trades have been out of the money. How do you know how far out the money you want to go to make a trade. -MB

As for “good trade” a lot has to do with my conviction level on the idea…..then I make an assessment where I think the stock can go if I am right in direction….but an important part of whether I use close to the money or out of the money options has less to do with fundamentals and more to do with whether I think the stock has the potential to outperform the implied move…..if I think it can, I will use out of the money as it is cheaper, and get more bang for your buck but lower probability…..I generally use a similar $ amount to most trades and that usually ranges form 1-2% of my options trading portfolio…..low conviction I use less and higher maybe a little more -Dan

I really appreciate the fast response. I’d like to drill down just a bit with one further question. Mike Khouw occasionally talks about the option premium as a percentage of the stock price. Do you use this type of measurement to determine if your option if expensive or cheap and if so, what parameters do you use. Here is why I am asking. In November I did a put spread on AMZN, based upon the chart. I purchased the April 85 put and sold the April 70. I wanted to give myself some time but it turned out that I was right the stock and wrong the option. I liquated when the stock hit 171 and made squat. Of course it was because I purchased too far out, but if I had a measure, such as the cost as a percentage of the stock price, I might have avoided this mistake. -MB

I think you are correct, and I do think about this. For instance you created a spread where the delta of both options were tiny, probably under 5%, so the chance of that 85 strike put you were long had almost an impossible chance of being in the money. So, if you used that same amount of premium and bought a smaller amount of options that had a far better probability of being in the money then you have a far better chance of making money, even if on a smaller bet….to purchase options way out of the money so that you can do them in large size is not a sound stratgy unless doing for a market hedge or as some call them a “black swan event”. So when I purchase options I often think about the percentage premium vs the stock price to give me a sense for the risk reward. For instance in AMZN when the stock was 200, if you bought the 190/180 put spread for 2.00 or 1% of the underlying stock price then you are risking 1% of the underlying to maybe make 8.00 (4%of the underlying) if the stock goes down 10% by expiration. That is how I think about it, I like to model events that I think are probable and then find a nice risk reward relationship and always look for a catalyst or a fundamental, technical or quantitative input that pushes me to make the trade

 

Just my luck… I missed that last six good trades and made up for it with two stinkers. I still love you.

I tried a couple of other stock picker sites and they SUCK! I think it is time that you expand you site and include not only your option trades but your long and short ideas… I would pay more for that and think most would agree. Something to think about while your sucking on a martini somewhere hot this holiday season. -JR

We are going to work towards putting out more thesis based ideas that may not exactly have trades attached, for instance names that we want to be long at certain levels or short at certain levels…..give reasons, maybe based on valuation or we perceive the market is miss-pricing the story. we are considering how best to do this….we dont want to get in a sitaution where we lay out a bull case for a stock and people just run out and buy it, we tend to be a bit tactical about entry and exits points…..as for cocktails I could use one with an umbrella in it. -Dan

 

What is your take on GS? This stock has been such a loser. Have been daytrading its options for the last week. DO you think its going to make lower lows? -MT

Great question and I am a bit fixated on it too……stock is the worst acting in the group and looks like the one that is about to break Nov lows first……as to whether it does your guess is as good as mine, but if you are defining your risk with long premium it is probably the way to go. -Dan

 

I would like to know if y’all have a standard stop loss, such as 50% or stops for profit at a double? -RT

Stops depend, and i am usually a bit more disciplined on the upside taking profits than cutting losses, but I often cut losses when I feel I am just wrong on the price action or the fundamentals….Stops generally work much better in stocks and etfs…..and in options I think of it a bit differently, my options trading is a small % of the overall investment thesis and should be considered the speculative component, not an investment strategy. So my options trades where I commit long premium I am generally risking what I am willing to lose. -Dan

 

@RiskReversal do we let the FDX dec/jan 82.50 put spread that Mike mentioned on Friday’s options action just expire in a few days?

Great, great question. Here’s why, 1) the trade worked out – stock is at that short strike and 2) if it dips below that short strike you’ll be put the stock.

Have to keep your eye on this one, but if you can’t manage to watch it like a hawk for two days, then cover and take the money. Here’s the odd part. If it expires just above the 82.50 strike, you’ll be simply long the jan 82.5 puts – a long premium bearish bet. However if it finishes just below the strike, you’ll be put the stock. Long stock/long put is synthetically equivalent to a long call, a bullish bet.

One of the tricky things with options as expiration approaches is that if you sat and did nothing you could, with only minimal differences in where the stock closes at expiration end up with very, very different types of positions coming out. -Mike Khouw

 

 

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