Ever hopeful that the market will effect the “healthy correction” that permabears have been expecting for, um, years, we acquired a small inventory of QQQ put options yesterday, paying a measly 0.15 apiece for sixteen January 40 puts. Our risk is $240, but the position has the potential to reward us with profits more than ten times that if the underlying index falls just five percent in the next month. While that prospect cannot be guaranteed, nor is it even likely, the risk:reward ratio is too fetching to pass up, especially with the stock market about to enter the New Year with so many technical indicators flashing red. My guess-timate is that the odds of a 5% decline over the next four weeks are about 25% to 30%. While this implies that our chances of coming away with a profit are less than stellar, our strategy is still appealing, especially considering we’re getting such long odds.

The January 40 puts had closed the previous day at 0.25, so by waiting a few hours, we bought them at a 40 percent discount. I put out an intraday advisory suggesting that you buy more of them, especially since all 0.15 bids earlier in the session had been filled almost instantaneously. But as the day wore on, and the QQQs rose somewhat higher, the January 40 puts became harder to buy. This seeming anomaly should be taken as an encouraging sign, suggesting as it did that the market-makers, for whatever reasons, were growing less and less enthusiastic about selling the puts, even with the QQQs on the rise.

Even Better Odds

Concerning the $240 we have put at risk in hopes of making a $2,000+ profit, the odds could conceivably become much better for us if certain things happen. As I mentioned in the intraday advisory, our goal is to spread off the risk by shorting January puts of a lower strike. Thus, having acquired sixteen January 40 puts for 0.15, we might now try to sell short sixteen January 38 puts for 0.15. That would make us long a $2 vertical put spread with nothing at risk except for the commissions we will have paid. Bottom line, there would be no risk no matter what the underlying index does, and we’d have a chance at making $3,200 if the QQQs, currently trading for 41.44,  were to fall below 38 within the next four weeks. Although, as I mentioned above, the chances of this occurring are not high, what do we care so long as the position has cost us nothing? This is the best way I have found to indulge our bearish suspicions about this market without sticking our necks out too far.

Let me note at this point that it would not be hard to recoup our costs in a day or two, even if the QQQs stay about where they are. This is because the market for January 39.625 puts is reflected at 0.10-0.15. If we were to successfully offer sixteen of them on Monday at 0.15, we would wind up with a 37.5-cent vertical put spread and no risk. That means we couldn’t lose a dime no matter what the QQQs do between now and January 20, but we could conceivably make $600. Of course, if the QQQs dive next week and we are able to short, say, sixteen January 38 puts for 0.25 (they are currently offered at 0.05), that would make us long a $2 vertical put spread (i.e., the January 38-40 QQQ put spread) for a 0.10 credit. That means the worst we could do is make $160 (less commissions); the best, to make $3,200 (again, less commissions.)

Broadly speaking, buying puts has been a losing game in a market that has defied gravity for most of the last two years. But if you can get the right odds, owning puts is not such a bad deal. This principle is one that I learned at an early age in the billiard parlor. My friend Jimmy (aka “The Can Opener, of blessed memory), would find the worst shooter in the place and stake him to a game of nine-ball against a player who could run ten racks in straight pool. Jimmy, at the time a high-schooler who left home at the age of 16, made his success by laying/taking the right odds. With just a bit of judicious handicapping, we can hope for similar success buying and shorting puts in certain, highly favorable combinations.