Our research mainly focuses on long opportunities (make money from a stock’s value appreciating), but along the way we uncover short opportunities (make money from a stock’s value depreciating) in companies with glaring red flags (as discussed last week). By buying out of the money (OTM) PUT options we are able to capitalize on these short-opportunities.
In this week’s “Topic of The Week,” we will discuss one of our PUT strategies.
- Conduct Due-Diligence (DD)
Similar to long positions, it’s important to understand the prospects of the company you’re betting against. Specifically, we seek to understand the company’s value proposition to consumers/physicians (usually through offering pharmaceutical products or medical devices/services). Once we discern that the company’s market capitalization exceeds fair value based on the near to intermediate-term earning potential we move onto Step 2. Other data points we look at include: Shares outstanding; cash position and burn rate; upcoming catalysts; leadership team, and market sentiment.
- Create a Plan; Trade the Plan
A rule of thumb we apply in the markets is; planning the trade and trading the plan. Oftentimes, mistakes are driven by emotional and reactive decisions. In order to mitigate this and avoid losses, we tend to plan out a price target, a capital allocation and investment pitch. This means we clearly state the thesis in a sentence or two and determine the timeframe in which we anticipate the stock moving down to a target price range. At this point we search the options chain for PUTs that are roughly 20-30% OTM.
- Buy on the pump
Red flag/fundamentally-questionable small cap biotechs frequently pump on relatively insignificant news. This creates immense opportunity for swing traders who are lucky enough to time the pump, but it arguably creates more consistent opportunities for bears. A significant pump on immaterial or overstated news is generally met with a pullback in share price. The reason being is that these types of catalytic events do not warrant the increase in market capitalization that results. By timing PUT purchases close to the top of the pump we can get the best price possible (PUT prices decrease as the share price increases).
- Manage position size
The fourth rule we always apply when buying puts is staying within our predefined capital allocation range. That means we only invest a small amount (relative to our account value) in order to keep losses minimal. Due to the incredibly volatile nature of PUTs (and options in general) we can realize meaningful profits without risking a lot of money. We personally allow a capital allocation of 0.50-2% of our speculative portfolios on put trades. It’s important to view money on options as money you’re willing to lose, thus the sum needs to be something you’re completely comfortable letting go of in the event of the trade going wrong.
Example: PAVmed Inc. (Nasdaq: PAVM)
Step 1: Conduct Due-Diligence (DD)
PAVM is an example of an inflated small-cap medical device company for which we bought OTM PUTS for. The stock has been on our radar for a while and when we saw it pump +64% in <1-month without news to justify a now $500M valuation we looked to PUT options. Before buying the options we reviewed its latest developments; the most notable one being its subsidiary (Lucid Diagnostics) launching its EsoGuard device for collecting cells from the esophagus; cells are tested for biological markers linked to Barrett’s Esophagus (BE)
Upon investigation we concluded that the device was unproven and would take time to garner physician adoption, if ever. Looking at PAVM’s 1Q21 earnings report and 10-Q we realized that it doesn’t even own the rights to the device (its subsidiary does) and even its subsidiary licensed it from another entity. Adding to the negative points, PAVM hit a double top on their chart, suggesting that the technicals are also aligned for a good PUT play. The bottom line was that we could not justify a market cap for PAVM over $100-200M with no revenue and unproven assets.
Step 2: Create a Plan; Trade the Plan
After completing our DD, we began monitoring for the most favorable risk reward profile on the options chain. Having surmised that $500m market cap was fundamentally overvalued, and the company faces several hurdles prior to fundamental progress, we honed in on July strikes.
At $5, a (16.30%) move places these strikes in-the-money (ITM) and would result in a higher premium than the current bid of 0.20 ($20 per contract).
With 31 days to expiration and catalysts for the larger markets on the horizon (Fed update on inflation opinion, and economic reports), we constructed a plan to add sub 0.20 per contract up until we hit our max capital allocation (0.5-2% of account value). Outside of unforeseen news highlighting fundamental developments, we set out to stick to our plan and lock profits if/when 100% gains are achieved.
The plan: Buy $5 put options for July 16 at or under 0.20 until we hit our max capital allocation allowed. Lock profits over 100%.
Step 3: Buy on the pump
Due to the volatile nature of fundamentally questionable companies, we waited for a green day to make our desired puts cheap (in our threshold of >0.20). We look to technicals and the chart to help us hone in on the right price to open a position. In the case of PAVM, we saw there was a double top forming at ~$6.50 and thus chose this range to buy our first contracts.
Step 4: Manage position size
As with beginning stock positions, we favour building our positions in 1/3s meaning with $1,000 we invest $333 at price 1, $333 at price 2 and the final sum at price 3. We do this in efforts to get the best average. It is nearly impossible to catch the bottom, but building the position we have planned in 1/3s allows us to average as close as possible to the bottom. Once we have reached our capital allocation threshold (0.50-2% of our speculative portfolio), we cut ourselves off from adding and wait for our plan to unfold. It’s important to make your plan before entering the trade and stick to it in order to eliminate as many emotions associated with the investment as possible.