Another Interesting Time to Buy Options

For the past several weeks we have been discussing how to make money buying options.  For those of you who have been following us for any extended time, you understand that this is a total departure from our long-standing belief that the best way to make maximum returns is to sell short-term options to someone else.

A combination of low option prices and high actual volatility has recently caused us to reverse our strategy.  Now seems to be a good time to be buying either or both puts or calls.  Rather than blindly buying an option and hoping for the best, we are continually on the look-out for something that will give us an edge in making this buying decision.

Last week we couldn’t find an edge we were comfortable with.  We considered buying a straddle on Thursday in advance of the jobs report but the market had been quiet all week and we sat on the sidelines.  Unfortunately, as it worked out.  SPY rose almost 2% on Friday and we would have easily doubled our money if we had pulled the trigger.

Today we will talk about one of those possible edges.

Another Interesting Time to Buy Options

It seems to happen every summer.  While the overall market doesn’t seem to do much of anything (that’s why they call it the summer doldrums I suppose), on many days, the market just seems to jump all over the place.  It could be that so many traders are on vacation that the few who are working are able to move the market with very few trades.

A more likely explanation is the computer-generated program trading that has taken over the market lately.  The average holding period for a stock in our country is now less than two seconds according to one study.  When the computers sense unusual buying or selling coming into the market, they place trades in advance of the orders getting to the exchanges.  This adds to the momentum and pushes the market sharply in one direction or the other.

At some point, the momentum shifts, and the market moves sharply in the other direction.

Check out the price action of SPY on Fridays for the past ten weeks:

June 1        -3.30
June 8        +1.05
June 15    +1.30  Monthly X dividend
June 22    +1.05
June 29     +3.31
July 6        -1.30
July 13        +2.20
July 20        -1.30    Monthly X dividend
July 27        +2.51
Aug 3        +2.70

If you had bought a slightly out-of-the-money put and call (or an at-the-money straddle) on essentially any one of the Thursdays preceding these Fridays, you would have surely made money when the stock moved well over a dollar the next day.  These puts and calls with only one day of remaining life are quite cheap, and could easily double or triple in value if the market moves by over $2 which it has on half of the Fridays this summer.

This edge probably does not extend to other months of the year, however.  In April and May, the stock did not move over $.75 on any Friday.  So it seems to be a summer phenomenon.

Buying options is risky business because you can lose 100% of your investment.  But doing it with small amounts when you see an edge like this Friday action (or before jobs reports, or on the Monday following the monthly option expiration), the odds may shift in your favor.

Be careful, and good luck.  Never invest money that you can’t afford to lose.