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

[paradigm]

I get it though...

The Australian economy is vulnerable... mainly depends on China/commodity exports...

And yes, the housing market is a bit rich... but mainly in the major cities. Sydney at the highest. Everybody wants to live close to the CBD and near the beaches... and there's not a lot of room to go, since we can't go East.

But IMO, there will be some pressure but a collapse I seriously doubt. There is still a lot of free standing housing in the major cities, which will (and is) change to more and more apartments. Developers are buying whole blocks for ridiculous per house prices, but with rezoning that will be redeveloped into apartment blocks and high rises. So those prices are warranted.

I think you might be reading a bit too much into the negativity at the moment...

CBA might drop a fair bit, but 0.... nah mate.

If I where you, I would aim for 50-ish... anything beyond that is a bonus.

Maybe 0 is a bit wishful but I disagree with the housing supply argument. In markets where there is a supply problem rental prices track with price for the houses. Not one-to-one but Australia's house-price-to-rental-price ratio has been diverging for years now and people have spoken of oversupply occurring in 2018 in terms of inner city apartment construction.

Either everyone is a drug dealer or I just miss the whole point

 

[JackRab]

Off course people aren't aware of the risk... they are sheepish...

We all go for the high yield. So when you don't look further or don't understand a prospectus... most will just shrug their shoulders and take the semi-fixed 5.1% because it looks good.
I did the same just before the GFC... so that was a bit shit...

But those hybrids have been around for a while... and there's nothing really wrong with them, until shit hits the fan.

Look, I'm not saying it's all great, but don't aim for 0 with 30 strike puts on a 85 AUD stock. Even if we drop 30%, those will not make much IMO. Better to go with 60 strike or so... you gain more on a decent drop....

 

[paradigm]

Off course people aren't aware of the risk... they are sheepish...

We all go for the high yield. So when you don't look further or don't understand a prospectus... most will just shrug their shoulders and take the semi-fixed 5.1% because it looks good.
I did the same just before the GFC... so that was a bit shit...

But those hybrids have been around for a while... and there's nothing really wrong with them, until shit hits the fan.

Look, I'm not saying it's all great, but don't aim for 0 with 30 strike puts on a 85 AUD stock. Even if we drop 30%, those will not make much IMO. Better to go with 60 strike or so... you gain more on a decent drop....

OK I am more on board with a more reasonable price assessment. In terms of the actual payment/coverage strategy though I like the idea of treating it like insurance rather than something to roll but my question remains. Is three months a standard? Is there a reason for this time frame?

 

[JackRab]

Maybe 0 is a bit wishful but I disagree with the housing supply argument. In markets where there is a supply problem rental prices track with price for the houses. Not one-to-one but Australia's house-price-to-rental-price ratio has been diverging for years now and people have spoken of oversupply occurring in 2018 in terms of inner city apartment construction.

Either everyone is a drug dealer or I just miss the whole point

Yeah that oversupply might come, but that's not necessarily going to be a major issue.

I think the stupid idea that 'negative gearing is great' has something to do with the low rents.

Is three months a standard time frame? I understand that time will effect the price of the option but are there any trade-offs/benefits to using say a six month rather than a three month. As long as I make sure that I am covered by the next set as the previous options expire then am I protecting my position? (even if you disagree with its reasoning)

Uhm, where shall I begin...

3 month options are a lot cheaper, but you might end up chasing the stock down and not making any money when the time value erodes...

In your case, I would go for longer dated... but good luck with that in the Ozzy market...

 

[sle]

Sorry, so why not buy index puts instead? It's cheaper and CBA getting any sort of a smack-down is a system-wise event anyway. Heck, if you think CBA is going down 50% I'd say S&P 500 puts might be the best play.

 

[sle]

PERLS are

I am away from my Bloomberg (really away, like 1000 miles), but aren't these exchangeable for common stock like convertible preferred stock, but subordinated in case of default (so better then preferred stock, but not a senior debt either)?

 

[paradigm]

Sorry, so why not buy index puts instead? It's cheaper and CBA getting any sort of a smack-down is a system-wise event anyway. Heck, if you think CBA is going down 50% I'd say S&P 500 puts might be the best play.

Is it THAT interconnected? I'd have to open an international options account somewhere...

I am away from my Bloomberg (really away, like 1000 miles), but aren't these exchangeable for common stock like convertible preferred stock, but subordinated in case of default (so better then preferred stock, but not a senior debt either)?

CBA PEARLS are, from their prospectus: "subordinated unsecured notes"

I also find it strange that they call them PEARLS when there is already another investment type commonly referred to as PEARLs that I believe has a better risk profile than these hybrids.

 

[paradigm]

Yeah that oversupply might come, but that's not necessarily going to be a major issue.

I think the stupid idea that 'negative gearing is great' has something to do with the low rents.



Uhm, where shall I begin...

3 month options are a lot cheaper, but you might end up chasing the stock down and not making any money when the time value erodes...

In your case, I would go for longer dated... but good luck with that in the Ozzy market...

Is there any way to protect against this chase down but not be locked in to 24 month illiquid markets?

For example, if I bought overlapping contracts ? Say, every three months I purchased a six month option so there was a consistent three-month overlap in holdings.

Do you know of any resources, articles, textbooks, etc. that cover such strategies? And have also been proven

 

[paradigm]

Is there any way to protect against this chase down but not be locked in to 24 month illiquid markets?

For example, if I bought overlapping contracts ? Say, every three months I purchased a six month option so there was a consistent three-month overlap in holdings.

Do you know of any resources, articles, textbooks, etc. that cover such strategies? And have also been proven

Replying to myself, I swear I'm not insane.

I will have a read of this "Options as a Strategic Investment" by Lawrence McMillan.

 

[Lee-]

My statements are not intended to critique your analysis and assumes you are correct, so just trying to provide another perspective.

Is your time horizon actually 2 years or could it be 2.5 or 3? It wouldn't be so pleasant to put your entire $10k in to options that will expire in 2 years only to see the crash happen 3 months later.

As ironchef already noted, once other investors wise up to the impending doom, the puts are going to become quite expensive. That they're not now means you're ahead of the curve. In order to get a good price on the puts, you need to open your put position on before everyone else realizes there's a massive problem. Waiting gives you the benefit of being able to extend out the time horizon for the crash, but has the risk that everyone else will realize it's going down and the puts will be more expensive. As long as you're still ahead of other investors, you'll get a good price, but since you're not finding liquidity in expirations 2 years out, waiting until it's not so far away may bring you liquidity and/or better prices (or at least a fill). Just another perspective on how to approach.

I do agree though that the bank going down will be a systemic. Do you have sector based ETFs or other indices in which you may be able to find better liquidity, but will also take a massive hit? What I mean is, if this banking stock goes down, will it cause an issue with other banking stocks? If so, a banking index or ETF might be worth looking at. How will exchange rates be affected? Will CBA failing cause another company, with possibly a more liquid options market, to also fail or be substantially impacted? For example, if this bank fails, then other businesses that rely heavily on debt will probably have a very difficult time getting capital to operate their business (even from other banks), so they may also take a large hit.

If what you're saying is true, that the housing market, exports, etc is all going to be a problem, I think it's wise to look at everything that may be impacted rather than focus on a single stock (particularly because the market isn't giving you what you want -- low strike, long dated, cheap puts), so you should look at alternative methods to capitalize on the same thesis.

Good luck.