Some thoughts on trading long puts

October 20th, 2009 · No Comments

As I’ve recently posted, I’ve expanded my trading strategies to include using long puts on range-bound equities exhibiting high volatility.  Even though I’ve only completed two round-trip executions of this strategy, both using AIG, I’ve already come up with a few notes that I want to record for the future.

Climbing the ladder to success

Climbing the ladder to success

The basics of the strategy are to buy puts when the underlying stock peaks, and then hold them while waiting for the underlying to drop, at which point a STC (sell to close) for the puts is done.  Because a put gives the holder the right to sell the underlying at the strike price, the price of the put options increase as the price of the underlying drops.  To be more explicit, if you have the right to sell stock at $50 at a time of your choosing during the next two weeks, but you could buy it today for only $40, that right is worth at least $10.  Back to the puts themselves, you can think about this strategy as an implementation of the old adage “buy low; sell high” where the lows and highs we’re aiming for are local maxima, over a day or two, in the price of the puts.

There are a number of risks to this strategy.  Probably the largest is that the underlying stock makes an extended move in the wrong direction, in this case that would mean the underlying’s price rises.  This can push the puts so far out of the money that the daily fluctuations (due to the high volatility we’re banking on) won’t be enough to move things back to a profit.   If this happens, you’ve either got to try and wait for the price to plummet again, or settle for taking some losses.  While your losses are limited to at most the price you paid for the puts, it’s not likely you want to lose 100% of that.  Instead, a better option is to enter a triggered order to sell your put options at a price that is near your tolerable loss limits.  You can’t simply use a limit order because a sell limit order will fill anytime the price is above the limit you set, and the price of our put should be well above that price right now.  A trigger order solves this by allowing you to specify the price at which your order will be placed, in this case you might want something like “if the price on my puts drops by $1.00, place a market sell order”.  In that example, we’re willing to lose about $100.00 per put.  Remember each put is 100 shares.

Another risk to this strategy is that the volatility of the underlying stock drops.  This will have a negative effect on the pricing of the puts because the volatility is directly related to the time premium of the options.  If the time premium goes down, so does the overall price of the option.   It should be obvious why this is bad.   What would make the volatility go down though?  This would happen if the underlying suddenly stops its wide price fluctuations and settles down to trading within a small range.   Probably the best way to guard against this situation is to use the same type of trigger order as mentioned above, only the driver behind the price drop is different.  It’s still a guard to limit losses.

The last risk worth mentioning is simply that of holding onto the puts for too long.  This is because, not only does it give fate more chance to do either of the two above mentioned things, but it also allows for decay in the time premium of the options.   And the time premium, on a highly volatile underlying like we’ve based this strategy on, is a large component of the price paid to originally buy the puts.  It will be quite hard to sell at a higher price if this all trickles away to nothing.   My current thoughts on protecting against this are to start the execution of the strategy by having a target time period over which you’re willing to wait for volatility to do its thing and push the prices of your puts to the high you’re aiming for.  As soon as that period expires, drop your target profit level and try again.  The amount you’d drop your target profit by depends on how the underlying has moved while you’ve been waiting; how much, if any, the volatility of the underlying has changed; and how fast the time premium is changing.   In my experiences so far, I’ve been aiming for profits that I thought were likely to hit within 2 days.  But after those two days, I’d generally be willing to drop my target by 50% to 75%, but keep in mind there is little math to back up those numbers on my part.   At least so far.

As you can probably tell by now, I usually establish a target profit before entering into the strategy.  And then as soon as the entry is executed, I enter a limit sell order to automatically take that profit should it occur.  Because I also want to enter that contingent loss limiting order, the profit taking order has to be a conditional order as well.  But while the loss contingency triggers a market order, the profit triggers a limit order.   I’m not sure this is strictly necessary, and it once meant the order got triggered but not filled.   However, it’s easy enough to cancel and reset the contingency trigger.

Tomorrow I’ll post a concrete example of this strategy by writing up the summary of my second long put adventure in AIG.

Tags: Options

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