I want to be clear. I don’t think anyone on Twitter or television is doing anyone a disservice when sighting options activity. It is a useful piece of information. But here’s the catch, as the prevalence of derivative plays make their way into every home office and kitchen across the country, increasingly, it’s not really “smart money” anymore.
I also think the options market, because of the way its currently discussed on social media and financial television, is a great way to get out of a position at a better price. Hear me out.
Let’s say I’m a large institution with a ton of Microsoft (MSFT) and I want to sell the position or scale down enough shares that would move the market. Rather then just hitting the bid over and over again, why not buy some upside calls, that are equal to at least half the position?
If MSFT is 43 and you can go out and buy 45 calls two months out for .50-.75, why not? A large block of options will have the watchers of options activity (like me) salivating. Soon it would be reported on social media, then financial television. As this process unfolds, MSFT would likely move 1-2% (the options much more). The institution could begin unloading the stock and the options, slowly but surely, most likely profiting nicely on the options and getting a better price for the stock. This seems like a pretty sound strategy.
Would this be guaranteed to work? No, but I’ve personally bought some of these hot options early in the AM, then flipped them for as much as 50% a few hours later as the news gets reported on television. It’s not the best feeling to be honest and you do have to be quick on the trigger.
By the time this “unusual activity” is well known, it’s very usual, just in a higher volume and the real gains have already been made. I’d recommend avoiding following anyone in simply on this catalyst though if you can spot it before you see it reported widely elsewhere, it can be rewarding, just don’t get greedy.
How Options Can Work
Say you want to buy a given stock and the price is $100. (I’m keeping the math simple on purpose). It doesn’t pay a dividend. To remain diversified you’re willing to buy 500 shares or $50,000 worth of this stock. You think the stock has 20% upside over 12 months with limited downside risk. Instead of laying out the $50,000 for 500 shares, you could look out 12 months and buy ITM (in the money options) with a DELTA of .80 or higher. (The closer a DELTA is to 1.00 the closer it is to mirroring the stock price movement dollar for dollar)
So let’s say the VIX is relatively low (The VIX is a key component in options pricing though do note that each stock has it’s “own” volatility) and you can buy a ITM call with a strike of 95, 12 months out for $6.25.
That puts you long the stock at 101.25 for 12 months, but here’s the catch, you’re outlaying just $3.125 for those options to be long the equivalent of 500 shares that would have cost you $50,000. Now if the stock is $100 12 months later, you lose the $1.25 you paid in “premium” and if the stock is at or below 95, you lose all your money and own nothing.
What you DON’T want to do is say to yourself, “Well, I was going to put up $50,000 in this stock so I’ll just do this strategy and put out $25,000 to get that much more exposure”. That’s genuine Wall Street parlance for a larger position. Good job out of you for using that term.
Not to worry, if you employ that strategy, you won’t have any money left soon enough and won’t have to think about options at all.
Weeklies are for Suckers
It’s probably safe to say that 90% of “investors” should avoid weekly options at all costs. Putting a long or short position on for a period that short term oriented is basically gambling, there’s nothing wrong with gambling, but lot’s not pretend it’s any sort of “investing”. Deal?
I would bet the people that make out the best in weekly options are the sellers.When you buy a weekly option, it’s a lot like buying a brand new car, it starts losing value the second you sign the papers when they are “out of the money”
If you want to make an earnings play with a call or put spread, that can work out if you’ve done your work, but mostly because you’re also a “seller” of some of the volatility in the weekly option as well as a buyer.
Remember, volatility is like anything else, buy low, sell high. So buy options with low volatility and sell options with high volatility, your margin of error is increased considerably.
I would also add that I find much more success with earnings plays using options that expire the week (or month) AFTER the release. Short term action in a stock following the report, I find, can be greatly influenced by options activity ,but by the end of the following week, the stock is usually trading where “it should be” based on the actual results. You’re also giving analysts and investors a weekend to go thru the results and issue upgrades or downgrades that can move the price. I’ve found much more success doing this so this is my preference.
Good luck out there. We all need some.