Learning to apply long puts using AIG

October 8th, 2009 · No Comments

So I’ve been watching AIG pretty closely given my current in-play covered call trade, and I’ve noticed that the daily highs and lows can be pretty large swings.  I’ve also noticed that, over the last few days, it seems to be swinging through the same range of prices over and over again.  Having just read about trading puts, I decided to dip my toe in the water by doing a long put with AIG.

Making income from volatility

Making income from volatility

The strategy I wanted to use for my “toe dip” was to place a One-Triggers-Other (OTO) trade on a single put option.  The single put so as to minimize the amount of money lost if something goes wrong.  Yes, I know that maximizes the losses from commissions but I’m in a learning mode here.  And the OTO so that I could use limit orders and not have to watch things constantly.  Also, this enforces the “take a good deal and not be greedy” mantra — lowers my risk of missing a good profit while waiting for a great profit.

Describing the whole thing another way, basically I would set a limit order to purchase a put option (“go long a put”), and when that got executed (the trigger), my broker would immediately turn around and automatically place another limit order to sell that same put option, but for a profit.  The outstanding question was how to decide what prices to use for the limits?

In my recent tracking of AIG, I had noticed that TradeKing was quoting 30-day historic volatility for AIG at “99”.  (As of right now, it’s down to 95)  It’s my understanding that the units of that quote are percent, so I think (please correct me if I’m wrong) that’s basically like saying AIG could double, or go bankrupt in 30 days.  That’s pretty freaking high volatility!  I then looked at more recent data, a chart of the last 5 trading days, and noticed that AIG seemed to be leveling off its recent steady climb and was range bound between the high $37s and high $46s, but it was mostly fluctuating mostly between $43 and $45.   I decided to try and buy an OTM put at a high above $45 and then sell anytime the option price rose by $0.50.  With OTM strikes having deltas around the low -0.4’s and high -0.3’s, when AIG was near $45, a $0.50 gain should mean a price drop in the underlying of about $2.50 to $3.00.

How likely was this to occur?  Well, I tried working out the math for that based on TradeKing’s 30-day historic volatility number, but never got comfortable I was doing it right.  Pretty much my math was telling me that there was about a 49.98% chance AIG would drop the requisite amount within a day.  And that there was a similar chance the option price would be what I was targeting for my profit after 10 days (roughly by October expiration.)

In the end, I skipped the rigourous math, punting on my “long put” spreadsheet for now, and did a gut feeling based on the 5 day charts.  I felt pretty comfortable that the necessary volatility was there simply by looking at the charts.  So the next step was to wait for a bit of an upward spike in AIG trading prices by placing a limit BTO order for the option at $2.50.  Recent trades had a time premium of $1.92, so this meant waiting for AIG to get above $45.58 ($2.50 – $1.92 + $45 (my target option’s strike)).  AIG was trading right around $45 when I placed my OTO order.   Note that I chose a just out-of-the-money strike in order to minimize the delta (delta is negative for put options).  The larger the absolute value of the delta, the more the option price moves when the underlying moves, thus minimizing the amount AIG would have to change for my profit target.  In the end, I decided to enter the following OTO order:

Order 1: BTO 1 IKG VS (Oct09 $45p) limit @ $2.50 (day-order, trigger for order 2)
Order 2: STC 1 IKG VS (Oct09 $45p) limit @ $3.00 (GTC)

And here’s the summary of the actual round-trip, executed trades.   You can see it took less than a day for my round-trip to complete.  As usual, I’m including my actual commissions in the numbers so that explains the fractions of a cent.

Critical Events:
2009.10.07: Initial position: BTO 1 IKG VS (Oct09 $45p) @ $2.556
2009.10.08: Close position: STC 1 IKG VS (Oct09 $45p) @ $2.9439

Days position held: 1
Capital investment: $255.60
Income received: $38.79
Percent return: 15.18%
Annualized yield: >1000%

It should be noted that, while I have a pretty good return percentage here, the risk is 100% loss (the put option expires worthless).  Realistically, I never planned to hold the put for more than two days, I would have simply sold and taken my loss at that point.  I find it very improbable that the put would become worthless during that kind of time period.  It’s gamma (or rate of decay of the time premium) was only 0.029, so it shouldn’t all leak away during two days. [EDIT: What I was thinking of here was theta.  Gamma is actually the rate of change in delta as the underlying’s price moves.  But now I can’t find the historic value of theta at the time of the original post, so I can’t confirm if I just had the wrong name or also the wrong value.]

I’m now wondering if it’s possible to use a One-Cancels-Other order to set both a loss limit order and a profit limit order.  For the trade above, I manually watched the prices on the option in order to gauge if I had to cancel my profit order and replace it with a loss limiting order.  Luckily, I never saw it go more than a few cents below what I had paid for it.

One last note, there was a sharp price drop in AIG today, which is why I got my $3.oo sell limit executed.  But it continued past my limit, and when I got the notice of execution for my limit, the IKG VS option was trading with a $3.26 mid-point between bid/ask.  That would have been an additional $25 in income, but there’s no way to gauge this unless you’re watching things real-time (which I can’t do.)   Anyone have any suggestions on a way to place broker orders that could automatically catch this gain?  Perhaps a conditional stop loss order of some sort?

Tags: Options · Trades

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