Nickel Options

I have a question for some of the more experienced options traders. Having personally not traded options through 2008, I am relying on experienced trades to share their knowledge.

For broad based indices like SPX, why do people buy FOTM put options for $.05 for the front month? I am talking about 40-50% out of the money put options. They expire worthless as historically, the market has never dropped 40% in a month. So then why are these options traded and often times in large volumes? Is it to protect against precipitous market drops, other advanced types of options trades, simply closing open positions? Or is it because they expect these nickel put options to go up in value enough to make it a viable trade even if it only happens once in 10 years?

Perhaps a related question is when markets tank dramatically, how high can these FOTM options that traded for a nickel a day before go? In theory, they could go to any level, but I am asking about real world cases. For example, in 2008, do any of you remember any specific example of FOTM puts trading at ridiculous prices? I am just trying to guage how much value such puts gain when the shit hits the fan.

Thanks,
Megadeth

 

sometimes it's the "lottery" trade. other times it's because someone sold those options months earlier when they were worth 1.00 and now they're closing their positions.

just use an options calculator to see what happens to them when spx drops 8% in a day and vix goes from 22 to 40, like in oct 2008.

 

Hmm... that is likely and certainly true. Some of these FOTM puts don't increase in value by much with sharp drop in markets and the volatility spike because only a few days are left to expiration and significant theta erosion has already occurred. However, I am asking more about empirical observations of MM marking up the prices for these options although the theoretical price is not even close. The real question is how high have the real prices deviated from the theoretical based on actual observation.

Megadeth

 

is it possible that someone may be using the delta value as a hedge?

 

I doubt it because ignoring IV change, it would take an index drop of nearly 100 points for that nickel option to do anything (if you buy the highest strike that costs a nickel and look for the highest stike that sells for a dime).

Without thinking, I'd guess it might be a margin consideration but in reality, creating such a wide spread could actually increase the margin requirement.

So I'd guess that it's just sellers closing out profitable positions.

 

I have often wondered that myself. Especially considering how much the option gains in price movement to the underlying. The only real answer I could come up with is someone who knows nothing about option trading and just buying what they think they can make a quick buck on. There are some so-called option "gurus" who actually this teach this crap as a way to make a lot of money with very little money!

 

This seems right to me.

In a world where anything ca happen, refusing to cover short options when they are available for 5 cents is a huge mistake.

Also: if a speculator wants to pay a nickel for some of those options, what's wrong with that? It's better than selling them for a nickel.

Mark

 

Help me out here: how is it that you are covering a short position by buying put options? If you are the option buyer, then you want to sell the underlying back on the market at the higher price as insurance against the stock decreasing in price. Why would you want to purchase an option that requires you to buy the stock at a much lower price? you cannot exercise the option if you don't have the stocks to sell !1

 

I write spy bull and bear spread on monthly basis,to generate regular stream of monthly income. But in March 2009 spy put which I sold for 40 cents went to $9.50 but at the same time my hedge of $.10 went to $5.10 It saved me a lot of grief.

 

The OP asked why people would buy FOTM SPX put options for $.05 for the front month that are 40-50% OTM. What we're suggesting is that if a month ago you sold those puts to open for a much larger amount, you'd be buying them now to close the position in order to take profits.

To buy them now as an opening position (not part of a more complex position) would make no sense since the index would have to drop a 100 points (a guesstimate) in order to make a nickel profit. IMO, not exactly a good bet.