Last week, we noted the high optimal hedging cost for Zynga could be a warning:

Steep hedging cost for $ZNGA (compare to last tweet re $QQQ). A red flag for Zynga longs? twitter.com/PortfolioArmor…

— Portfolio Armor (@PortfolioArmor) February 9, 2012

This was the “last tweet re $QQQ” referred to in the tweet above.

Zynga tanked almost 18% today after posting a net loss of $435 million, on a $510 million charge associated with stock-based compensation issued to its employees.

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- Also bought puts on the Treasury bond-tracking ETF TLT on Monday.

- Related to the item above, this article of mine published on Seeking Alpha Tuesday, suggesting those who own TLT consider hedging it, while it was relatively cheap to do so.

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I wrote the two articles linked to below last month.  They proved to be good timing. After writing the second one, and noticing how optimal hedging costs on the gold-tracking ETF GLD had been climbing fast, I decided to buy puts on GLD myself, as a speculative bearish bet against it. Those puts were up 120% today.

- “Why you should consider hedging if you own gold”.

- “Gold goes parabolic, hedging costs rise”

These were the optimal puts to mentioned in that second article; the ones to hedge against a greater-than-20% drop in GLD over the next several months on 8/22:

Those puts on Friday:

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And this follow up Monday night (published yesterday), in which I noted that the hedging costs mentioned in the first article had doubled: “Gold goes parabolic, hedging costs rise“. I took that spike in hedging costs as a bearish signal, and placed a small bet against GLD yesterday, which is up about 27% so far today.

Hedging costs have continued to rise since Monday, unsurprisingly, as GLD has dropped. This was the screen print of the optimal puts Portfolio Armor presented on Monday as a hedge against a >20% drop in the gold-tracking ETF $GLD between then and mid-March:

After today’s drop in gold and GLD, the ask price on those puts has risen to $6.50.

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• Start small (since options often expire worthless).
• Avoid out-of-the-money-options (instead, try to get ones with some intrinsic value).
• Avoid nearby expiration dates (to avoid theta burn and give positions more time to work out).
• Buy options at a discount to model estimates of their fair market value.

I’ve been making bullish and bearish bets to increase the chances that some bets will make money whatever direction the market takes over the next several months. I’ve also been trying to take advantage of relatively low volatility when buying options (though if volatility keeps ticking up, I may start to hold off on making new speculative options buys).

On Tuesday night I placed limit orders for several small bullish and bearish bets. I got a fill on a two of them during the day Wednesday, calls on IXYS and puts on OMER. More on those below. First, a recap of my modus operandi here, and a reminder about the difference between speculative options buying and hedging.

Looking for Speculative Options Bets

For the bearish bets, I’ve been starting by scanning for relatively lightly-traded (average daily volume over the last month of < 200k-225k shares), optionable stocks that look weak technically and fundamentally. The idea behind looking for relatively thinly-traded stocks is that the options traded on them are more likely to be thinly-traded, which increases the chances that they might be inefficiently priced. Then I look for in-the-money puts on them several months out, and compare the current bid-ask prices for them with the estimated fair market value of them via the Black-Scholes model.

If I find one where the most recent bid is significantly below the Black-Scholes fair market value estimate, I’ll place a small limit order for it, with the limit price set at a ~20%+ discount to the fair market value estimate.

For the bullish bets, I’ve been doing the reverse: Scanning for stocks that look strong technically and fundamentally, and looking for in-the-money calls priced below the Black-Scholes estimates of their fair market value.

Prior to today, I used this M.O. to purchase puts on JOE, NAK, MOTR, TNDM; and calls on HMC, HIT, COHR, SUP, and ASMI. I noted these purchases at the time on the Short Screen message boards.

Hedging vs. Betting

If I were hedging, I would enter the symbol of the stock or ETF I was looking to hedge in the “symbol” field of Portfolio Armor (available as a web app and as an Apple iOS app), enter the number of shares in the “shares owned” field, and then enter the maximum decline I was willing to risk in the “threshold” field. Then Portfolio Armor would use its algorithm to scan for the optimal puts to give me that level of protection at the lowest cost.

On rare occasions (I’ve seen it happen once, so far) the optimal puts Portfolio Armor presents might be in-the-money; in most cases however they will be out-of-the-money. Since I’m making a directional bet in the cases below, though, and not hedging, I bought slightly in-the-money options. This makes sense for directional bets (when you are willing to pay more to reduce the odds against your bet) but would be sub-optimal in most cases for hedging (when you want to get a certain level of protection at the lowest possible cost).

A Bullish Bet

IXYS Corporation (IXYS) is a an integrated semiconductor company.

IXYS has a PEG Ratio of 0.29, based on analysts’ estimates of its earnings over the next five years.

As of Tuesday’s close, the Black-Scholes estimate of the fair market value of IXYS’s $15 strike, October calls was $2.23. I bought them for $1.80 Wednesday (the B-S estimate of their fair market value dropped to $1.97 after Wednesday’s drop in price of the underlying).

A Bearish Bet

Omeros Corporation (OMER) is a clinical-stage biopharmaceutical company. These are the kinds of stocks I generally prefer to bet against with puts rather than by shorting them, because they can spike on news of an FDA approval, or a partnership deal with a big pharma company.

OMER has a PEG ratio of -0.4 based on analysts’ estimates of its (negative, expected) earnings over the next five years.

As  of Tuesday’s close, the Black-Scholes estimate of the fair market value of the $7.50 strike, November puts on OMER was $3.50. I bought them at $2.85 Wednesday (the B-S estimate of their fair market value rose slightly to $3.57 after the drop in the underllying Wednesday).

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– Victor Davis Hanson: “Bin laden Fallout”
– Christopher Hitchens: “Death of a Madman”

A profile of a manufacturing entrepreneur in Britain, via the FT:

– “A Bastion of British Engineering”.

A couple of brief excerpts:

I started this business in a one-car garage with no money and I started it to make myself wealthy

[...]

I was 42, with a garage and no money. I had a great idea for a needle valve. I got out a T-square and designed a valve and made it. We have just made the five millionth one

A few recent articles of mine published on Seeking Alpha:

– Exxon Mobil: The Anti-GE. My most widely-read article there so far, I think.

– Revisiting Hedging Costs after Bin Laden’s Death.

– 2 Bullish Options Bets on a Down Day. This one spells out my newish M.O. for making speculative options bets and differentiates speculative options buying from hedging.

– Rating 5 Companies with Factories in the Rust Belt. A riff on an FT article earlier this week about some slim green shoots in Rust Belt manufacturing.

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