How to make a deeply out-of-the-money market

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paradigm

Hi,

Let's say that I have reason to believe that a company is going to go bankrupt. I have a timeline of two years and the current price of the stock is $100.

I believe it is going to $0 so I want to buy as many put options as I can with my capital which is $10,000. The current market for two year options is small because it's a long time away and most of the available markets are for options with strike prices around $70 at "best".

Ideally if I know it is going to $0 I would like to buy the maximum amount of contracts.

Let's say that based on 22% volatility (implied volatility is 19-21 for the options available in two years and historical volatility at the moment is 18% but I thought 22% to make it harder on myself).

At a strike price of $30, based on Black-Scholes, I can price an option at $0.001 which is the smallest denomination I can trade in.

This would allow me to buy many many options (if anyone would write them) and would increase exposure for writer's to absurd levels.

So based on that I know that the most extreme would most likely not get written because no one in their right mind would take on that level of exposure (let's pretend that the actors are rational).

How do I price an option so that it is both worth the writer's risk but also so that I can still buy enough options to make the risk worth the investment?
 
So you want to know at what price someone would sell you a few thousand of those puts? That would depend on the liquidity of the options in general. Whether the seller (likely a market maker) is able to hedge by buying a decent volume of other puts, since that 30 strike isn't exactly hedge-able with shorting stock (very low delta).

But, I would say, at a theoretical value of zero-ish... the market could be something like @0.05... but again, depending on liquidity it could also be @0.20...
 
JackRab said:
So you want to know at what price someone would sell you a few thousand of those puts? That would depend on the liquidity of the options in general. Whether the seller (likely a market maker) is able to hedge by buying a decent volume of other puts, since that 30 strike isn't exactly hedge-able with shorting stock (very low delta).

But, I would say, at a theoretical value of zero-ish... the market could be something like @0.05... but again, depending on liquidity it could also be @0.20...
More...

Thanks for your response.

Are there any strategies for illiquid markets to optimize my position (i.e. buy as many contracts as possible)? The two year market is illiquid but the rolling 3-month market has some volume in it. Is there some way to take advantage of those properties of the market?
 
Well.. if you are going to roll every 3 months, you're probably losing the full premium most of the time... So you should not invest the full 10k each time.

You would need to see it as an insurance... you want to take out insurance for the next 2 years. You either pay 10k for the full coverage. Or 1250 every 3 months...

With the second strategy, you probably can get a higher strike price, since values drop significantly. You'd be looking at the 70 strike or something... so the payoff would be bigger per option.

You're not giving a lot of detail here... I'm just guessing since I have no clue what stock we're talking about....
 
paradigm said:
Hi,

Let's say that I have reason to believe that a company is going to go bankrupt. I have a timeline of two years and the current price of the stock is $100.

I believe it is going to $0 so I want to buy as many put options as I can with my capital which is $10,000. The current market for two year options is small because it's a long time away and most of the available markets are for options with strike prices around $70 at "best".

Ideally if I know it is going to $0 I would like to buy the maximum amount of contracts.

Let's say that based on 22% volatility (implied volatility is 19-21 for the options available in two years and historical volatility at the moment is 18% but I thought 22% to make it harder on myself).

At a strike price of $30, based on Black-Scholes, I can price an option at $0.001 which is the smallest denomination I can trade in.

This would allow me to buy many many options (if anyone would write them) and would increase exposure for writer's to absurd levels.

So based on that I know that the most extreme would most likely not get written because no one in their right mind would take on that level of exposure (let's pretend that the actors are rational).

How do I price an option so that it is both worth the writer's risk but also so that I can still buy enough options to make the risk worth the investment?
More...

Whats the lowest strike 2 years out that you see right now and whats the bid/ask?
And same for 1 year out.
 
http://www.asx.com.au/asx/markets/optionPrices.do?by=underlyingCode&underlyingCode=CBA

Sorry that the format is so terrible but those are the best I can do without linking to something behind a paywall.

I see what you're both saying about liquidity and it might be wiser to trade in the shorter term and just roll positions. I'm new to options and understand the basics of their mechanics but not how to optimize my risk / reward.

My thesis is that CBA will be trading at a severe discount to current price if not $0 and I have $10,000 to put towards that thesis.

How much more risk would rolling short term options introduce into the strategy? Rolling assumes I have someone to sell the option to right? So I can fund the next set of options, especially if the options with similar strike prices in the next time-period have deltas closer to -1 than the options I am holding.

Also if the market marks my options as worthless would I even be able to roll or would I just have to wait for my position to expire and just fund a whole new set of options without any proceeds from the previous set of options?
 
Unless you are an insider with non public information, if your analysis determines that the company is going to go under, chances are many other traders will also see the same so the put options will be very expensive, often with volatility in the hundreds of % (I looked at RIG at one time).

And if you are trading with insider information that is non public, it is illegal.

There are so many smart professional options traders, it is extremely difficult for non professionals to trade profitably doing the usual, so, you are thinking the right way if you are a non professional like me.

Good luck.
 
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