MRK option play

Discussion in 'Options' started by Babak, Aug 28, 2005.

  1. Babak


    What do you guys think about a play along these line:

    When a stock, in this case I'll use MRK as an example, takes a dump on bad news that doesn't really affect their future...especially if they are well capitalized ... you sell long dated puts at a price slightly below LT support.

    In MRKs case, I think that would be $25ish. The idea is to sell the fear volatility built into the dump move. And the close would depend on how the stock fares. If it bounces immediately (1-2 months) you cover for a quick profit. If it doesn't you let it ride out for a nice % pa return.

    Another recent example might be CIBC (Enron settlement).

    The only problem I can see is that if you don't capture the stock as it is dumping with extreme fear you may not have much volatility to sell later on. For example, MRK has settled down into a price range now and the vol. has also settled down.

    An ATM 27.5 strike Apr'06 put would only give you around 14% return and a 25 strike Apr06 would give you 8% return. Measely and not worth the position's risk IMHO.

    Any ideas re this?
  2. Based on your scenario, you probably would want to sell short dated puts instead of long dated puts because the time decay on the long dated puts would be very minimal.
  3. Babak


    Yeah, I thought so too. But this book that I'm just reading has another take on it that is interesting (Cohen - Selling Puts).

    He says that he likes long dated puts (LEAPS) for two reasons. One, they lower your BE much more than short dated ones. And two, they let you have more time to allow the stock to move up. As well, they have the benefit that if the stock immediately moves up (like MRK in this example did in fact) then you can close out your position or reset it w/o a problem.

    The only catch that I can see in his advised strategy is that I've heard LEAPS usually do not respond as well to underlying movements because they are so far out there. So you could have a stock moving w/o gaining on your option short position as much as you theoretically should.

    I guess it depends on how far you go. Something crazy like 18+ months might put you in that spot. But I think anywhere below 9 months is ok. Like the MRK example I gave above.
  4. It depends on whether you are trying to capture the volatility crush or the directional movement. For the former, you want vega which the long dated puts give you. For the latter you want gamma. Probably better off just buying the common for a directional play however or selling a put vertical.

    Another approach if you anticipate a relatively large move sometime in the distant future, is to buy a long -dated call and sell short-dated call verticals. This is a variation of Cottle's slingshot hedge.
  5. Babak



    I like the way you put it: vol. crush. That's pretty much it. I'm basically betting that the sky isn't falling not that its going to bounce. Usually - not always! - when a leading company is dealt a blow like MRK or CMB or VNT, they don't bounce back. They recover a little bit then tread sideways. Then, after a bit of chop they might move up.

    This same thing basically happened with GM. Take a look at all those charts and you'll see what I mean.

    The conditions are that it has to be a widely held company, stalwart, large cap, liquid, etc. And spike down on bad news. The probability is always there that you'll have an Enron explode in your face but that's a very, very small chance IMHO.