Buying calls at the end of the move down (panic selling) may appear to be a great play; however, since all options are most likely pumped up with so much juice, you get the upward move that you anticipated. Unfortunately, volatility contracts as the market moves higher and the profit you thought you had turns out to be minimal or even a loss!
I'll give a novice wrap up of what happened: A relatively sleepy stock breaks out from 8 to say 13 on news. I do not know the bid/ask on its APR 10 PUTS "the puts" but expect that they were down that day. At around 12$ or so/share on heavy volume, it becomes apparent to a group of traders that the news is a sham and they quickly descend on the CBOE and Philly and buy up puts between .90 and 1.20 but not so many that an orderly market for these options is upset or the exchanges tipped that something is obviously up. Next day, the stock tanks to 9 yet those options at best sell for 1.50 and actually settle down to around 1.20. Many involved thought they would jump quite a bit more in value. Without knowing more, my guess would be that they were way overpriced from before the breakout. Curious as to comments? And thanks. Geo.
In the scenarios described above a trader can protect himself or even take advantage of that vol spike situation by structuring trades in a way to take advantage of the spike and still profit from forecasted direction or at least not get hurt too much in the situation that freehouse described. One of the better ways it to initiate put/call spreads in lieu of outright purchases of calls/puts. Freehouse's example is a classc example of why poor implementation of trades result in traders giving up on options. They fade the stock breakout by buying puts to profit from reversal. However, they fail to notice that the IV of that strike has been rising the past days from 30-50 vol . The stock drops 3$ but to their dismay see their 50 delta puts only appreciate by 80 cents. In that scenario, the PnL can be greatly improved by putting on a put spread instead which makes the position only delta exposed and not vega exposed. In addition, if there is a good IV differential between months, traders can even buy the out of the money calendar (selling front month and buying lower IV (hopefully) back month ) So when stock reverses to the lower strike, their calendar starts making $. Hope this helps
If you're confident that the market is going to move one way (i.e. aforementioned news example) you are almost always better off buying/selling the stock outright. If this is a problem due to capital limitations, consider selling the opposite contract (i.e. selling calls as opposed to buying puts). IMHO, the key to successful options trading is selling 3x as many options as you buy. Of course, this is not a strategy advisable for beginners, and it is advantageous to know when to take a loss (rebuy the option to cover) and when to say when...things that only come over time.
Could you explain a bit more about the last part of your reply for those of us who are options newbies? Thanks.
There you go. (Let me clarify my earlier statement - sell at least 3x as many contracts as you buy). Let's face it - the people behind firms who price and sell options are a lot smarter than you are - they fully intend to make money at least 90% of the time. Do you really want to take the opposite side of their trades?
To Babak. A calendar or time spread involves buying the back month and selling the front month usually at the same strike price. The calendar spread has a risk profile wherein the spread makes money when the stock hovers near or better yet at the stirke price of your calendar. An example would be better so here it is. Stock explodes from 40-50 in a week, you think it is not sustainable. The market bids up the front month from 30-40 volatility while the back month is still the same vol at 32. So you'd buy May 45call at 32 imp Vol(IV) and sell April 45Call at 40 IV. Since the IV differential is susbtantial you'd end upbuying that calendar really cheap maybe $1.40 instead of the theoretical $2.00. You have a high probability of making $ if certain scenarios happen. 1. Stock retraces to 45 and sits there. Your front month would decay much faster than the back month. 2. IV diff between two months revert to their usual value which means the spread expands the calendar value from 1.40 to $1.90 without anything happening to the stock. 3. You hit a homerun if the Iv narrows and the stock goes to 45 and sits since your april call goes to near zero so spread value goes up dramatically near expiration. You might lose some $ if the general IV of the entire series collapses since you are long vega, so you should always be aware of not just the IV between the months but also the IV of all the options. Hope this helps
WOW...I'm wondering if you took the same trade I did about one week ago. Your post sounds eerily familiar!