The general theory is the fact that explosive volume has a tendency to wash out the sellers from the market, providing opportunity for the buyers to return and bid up the share price to higher levels. Hence the saying "bottom fishing stocks" - you're trawling for stocks at what you believe could be the bottom levels of it's price action and ready for a turnaround.
Buying These Stocks at a Discount
If you have been educated about option trading you'll be aware that you can both buy (go long) or sell (go short) option contracts. You'll also realize that in the usa one option contract covers 100 shares while in other countries such as Australia, they give you control over 1,000 shares - so you should bear this in mind when deciding on the level of capital you wish to invest. Do you plan to purchase multiples of 100 or 1000 shares?
The simplest way to illustrate bottom fishing stocks for a discount using options would be to create our own imaginary example. Suppose XYZ company stocks have recently fallen significantly to around $17 on large trading volume - sometimes called 'capitulation volume'. The stock has since been trading in a price range and you believe it can't fall much further so it will still be a good buy if it goes as far as the $15 price level. You also possess enough capital to acquire 500 shares.
This is what you can do:
You sell 5 put option contracts at a strike price of $15 for expiry next month and also buy an additional 5 put option contracts with a lower exercise price, same expiry date. This is called a put credit spread, also known as a "bull put spread". You'll need the bought position as a kind of insurance safeguard should the stock plummet further. You will receive a net credit into your brokerage account. Once this is accomplished, three scenarios can follow:
1. The stock remains around the $17 level by option expiry date. In this instance you're able to keep the credit you've received and can elect to sell another put credit spread for the following month. You have effectively been compensated for waiting for the stock to reach your desired level.
2. The stock falls to $15 and you are exercised on your sold options and the stock is put to you. You now own 500 shares of XYZ and can then implement further strategies using options, such as selling covered calls with protected puts.
3. The stock continues its decline to way below $15. In such cases, the stock will be assigned to you, however your bought puts will improve in value and limit your potential losses. You could use the profit from these bought puts to buy more shares and in doing this, average down your entry price as part of a longer term wealth building plan.
Bottom Fishing Stocks Using Inflated Option Prices
One good reason bottom fishing stocks is the best time to make use of this strategy, is the fact that due to the huge stock selloff, the implied volatility in put option prices will normally be high. This means that the near-money options you sell will probably be at inflated prices, thus giving you a better credit for the transaction. You receive a handsome sum for simply waiting for the stock to fall further - whether or not it does.
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