Holding Put Options? Follow This Simple Rule…

The Dow Industrials have rallied 367 points from Friday’s oversold lows, a feat that looks much less impressive when you consider that the blue chip average had lost 980 points in the preceding two weeks. Most of the frenetic buying over the last two days has been done by panicky bears who literally got caught short when stocks exploded on the opening bell Tuesday. We got caught mildly short at the turn ourselves after having broken a rule that anyone who trades options should heed rigorously – i.e., never, ever pass up an opportunity to take a partial profit when a put trade goes your way for three straight days.

The Mini-S&P has about 10 more points of running room before it hits real supply

Too bad we didn’t do as we say, since it would have given the theoretical gain we achieved anyway a nice boost. Although we’d correctly predicted a 96.13 low in the Diamonds that came within 0.04 points of nailing Monday night’s key bottom, we let our bearish position ride. Dumb. Any time an option trader fails to adjust a put position after three consecutive profitable days, he is just being greedy. Statistically speaking, a three-day selloff is probably as good as it will ever get – a fact that held true even in the case of the October 1987 Crash. It may have seemed as though the world was ending at the time, but in actuality, anyone who bought puts on Friday, October 16, when stocks began to plunge, had to be out of them by Tuesday morning, October 20, to avoid one of the nastiest whiplash rallies in stock-market history.

97% Losers

Naked put buyers have probably lost money 97% of the time since options were first listed in 1973, but it is still possible to beat the odds.  We attempted to do so by exiting July 96 Diamond puts near yesterday’s opening, realizing a theoretical gain on each put of 27 cents just before they plummeted toward zero. Applying the paper gain to some August 98 puts that we still hold, and to a few more that we acquired yesterday for an average 2.65, gave us an adjusted theoretical cost basis of 2.13.  It helped that we waited for a 270-point rally to unfold before adding to our put position.  The decision to do so was based on the very bullish projection that went out Tuesday night for the E-Mini S&Ps.  We were expecting a monster rally to 1049.25: “…there are obviously more than a few panicky shorts still alive. They’ll get what they deserve…if the futures push above 1027.50 [on Wednesday]. More bullish still would be a move above 1031.50, the midpoint resistance of the pattern begun from yesterday’s low. It projects as high as 1049.25.”

In the actual event, the futures rallied yesterday to 1059.50.  As the above chart shows, they could go for another 10 (or so) points on Thursday before running into serious resistance. With any luck, we’ll still have a little dry powder left to buy some more put options when the rally finally tops out.

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  • gary leibowitz July 9, 2010, 3:22 pm

    I absolutely agree with you that manipulation does occur especially during the opening bell.

    In the end all it does is create a build-up of pressure when a dire economic situation becomes clear. It actually creates its own worse scenario. Preventing orderly selling during these times creates crashes. Ironic aint it.

  • gary leibowitz July 8, 2010, 11:37 pm

    You hit it on the nail. My frantic expectation for an immediate crash stalled when i saw that 1020 on the SPX was holding very well.

    I have a possible high for this round of SPX of 1080 – 1090. 61.8 percent rebound from the recent drop, or 38.2 percent from the recent high of 1220. I will stick my neck out and say there is no way we hit 1220 again.

    I am expecting a nasty steep drop and I am still expecting it to happen this summer.

    I was one that took a beating buying PUTS this last 2 weeks. Recently I have bet only long-shots and expect to lose most of my cash on these types of bets. I still think the risk/reward during times like this is worth it.

    Unless we clear 1110 on the SPX I will still pounce on any indication we are about to fall hard.

    Granted, this is not a normal way of playing the game, but I have waited over 15 months to get my feet wet. I did the same thing 17 months ago and lost my OTM puts before I finally cashed in on the crash. Hoping for a repeat.

    • gary leibowitz July 8, 2010, 11:43 pm

      BTW, has any compiled a recent review of quarterly earnings coming out? Usually companies place conservative numbers so they don’t disappoint. This time around watch for the forward looking numbers. A hunch it will not be pretty.

  • Robert July 8, 2010, 11:35 pm

    I like the three day rule…. that’s a keeper.

    As an options trader- I’m a rookie who mainly only issues put options against companies whose shares I won’t mind owning if they hit the strike. This strategy has made me steady (if not huge) money in the miners for years.

    With the miners (especially silver miners) getting beat down pretty good lately relative to the metals, I’ve been thinking about buying long dated calls on a few Silver names with heavy short open interest at strike prices 20-30% higher than they are currently trading. That way I’d be positioned to book some profit if they sky-rocket, without having to allocate the cash to the shares right now…

  • Rich July 8, 2010, 7:33 pm

    “Naked put buyers have probably lost money 97% of the time since options were first listed in 1973,”

    Recall getting into an argument with the Stanford Business School Options Textbook author/professor over that one.

    My experience confirms that one, plus slightly lower percentage for naked calls, maybe 66%.

    The point about the three days in 1987 is invaluable.

    Most put buyers I knew, including myself, took profits when the Dow dropped the then unprecedented 108 points (4.6%) on Friday, only to gape in dismay as the Dow dropped 508 points (22.6%) on Monday and swallowed up everyone but Prechterites, who had a hot hand.

    The following few months took care of them…

    Selling half the puts on Friday and the rest Black Monday or Tuesday opening worked a lot better.

    Good money management points from the PCoast floor and since appreciated, Rick…

    &&&&&&’

    Just so, Rich. With the market down 108 points that Friday, I was buying Cray Research shares hand-over-fist. I even disdained to cover hundreds of October 70 puts I was short for $25 apiece with the stock sitting at $70. They cost me $3,300 apiece to get back on Monday when CYR opened at $37.

    One might have thought that “down 108 points” met Rothschild’s criterion for blood running in the streets. Who knew what real blood looked like? RA

    • Rich July 8, 2010, 11:41 pm

      Valuable lessons gracefully preparing us for prosperity…

  • Rich July 8, 2010, 5:00 pm

    Agree with taking profits on half when available, particularly with a double or better.
    On the other hand, some of the biggest mistakes made were taking profits too soon in 1974, 1982, 1987, 2008.
    That’s why Trailing Stops seem to work better.
    Looks like we’re seeing some profit taking this AM.
    Would not be surprised to see higher highs today and tomorrow…

    &&&&&

    Trailing stops are guaranteed not to work in powerful moves, since the adverse swings will always exceed the limitation of a prudent stop-loss. A good book to help get the stops right is “Dynamic Trendline Charting”. RA

    • Rich July 8, 2010, 6:46 pm

      Thanks for the reference Rick.
      Set MOC Trailing Stops based on volatility, which does lag monster moves.
      Think we may have one coming up next week.
      TWAT (Time Will Always Tell).
      Meanwhile, we seem to be in the eye of the upsquall, with APC running the shorts…

  • mario cavolo July 8, 2010, 2:34 pm

    Nice solid wise rule Rick…the past six months I have done quite well with the shorter term trade time frame, and I have consistently seen that if my position has moved long or short as I wish for 3 days, it AIN”T gonna do it a fourth day!….Admittedly I have gotten out many times earlier and lost some profit, but I got out WITH profit! If I’ve learned one lesson in the past year its that 2-5% gains are a fabulous gain several times per month…it adds up. So, take your profits boys….Cheers, Mario

  • Benjamin July 8, 2010, 3:23 am

    “Most of the frenetic buying over the last two days has been done by panicky bears who literally got caught short when stocks exploded on the opening bell Tuesday.”

    Man, I couldn’t possibly do this stuff. I’ve tried familiarizing myself with the terms, but I’m just too learning impared to understand stocks, options, etc. Gimme gold/silver ratio trading any day!

    But anyway, still, one thing I couldn’t help but notice was that we were on a long, holiday weekend (the markets were closed Monday, right?). And what tends to happen after long holiday weekends? The PPT struck again!

  • FranSix July 8, 2010, 2:41 am

    Consider if you will the amount of naked shorting in the markets which require settlement if the fundamentals move against you, and that you are only settling a ‘sell’ is you buy into the market, not necessarily buying shares.

    The discount rate is showing a decline this week, we may see more net settlements before the week is out.