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Sometimes, Wall Street has a very convoluted way of looking at things. For instance, consider the term “smart money.” One would think the term “smart money” would refer to a professional investor with incredible talent or a fund manager, market strategist or analyst that has had consistent success over different market scenarios, spanning many years.

Or perhaps a trader/investor who has an intimate knowledge of the market and has mastered the tools of his trade, including technical and fundamental analyses, hedging and option theory, and an expert knowledge of the global economy.

Wouldn’t this definition be a better fit for the term “smart money”? Maybe, but not in Wall Street’s eyes. On Wall Street, the term “smart money” refers to someone with ‘privileged’ information, who uses it to their advantage. This person, fund, or group doesn’t necessarily have any special ability, talent or expertise.

They only know something that the public has not been made privy to. They have a piece of insider information that they sometimes use illegally to profit in the market. It happens all the time. So, on Wall Street, “smart money” is often synonymous with cheating or illegal activity.

For many years, most professional traders and even individual investors have studied long and hard in order to acquire skills that would aid them in their quest to be better, more competent traders or investors. However, not having access to the same level of information as ‘smart money’ sometimes puts the retail investor at an extreme disadvantage.

A person with insider information has a crystal ball. He knows the outcome of the game before the game is even played. The SEC has rules in place to try to prevent this from happening but these rules haven’t eliminated the problem because the SEC cannot always ‘prove’ their case. Therefore, there is still a lot of “smart money” out there.
Most “smart money” traders try to keep a very low profile for obvious reasons. The easiest way for them to do this is in the options market where there are fewer participants thus fewer eyes and ears to notice any unusual trading.

Further, the options markets offer much greater leverage, allowing “smart money” to reap even greater rewards. For example, If you knew that XYZ stock was going to report bad earnings, and you knew this ahead of the ‘market’, it would be much cheaper and more profitable buying puts in the options markets as compared to just shorting the stock.

This is exactly what happens, and it happens more than you think. The game is always easier when you know the outcome before everyone else, and these ‘smart money’ players are out there making fortunes in the options markets because they know what you don’t.

“Follow in the footsteps of elephants”

What do we mean by this?

When a stock’s option volume and implied volatility increase significantly, it is often a harbinger of things to come. Although the stock’s price action may seem quiet and uneventful, not reflecting any unusual activity, the stock’s option activity can be telling a very different story.

An unusual and greater than normal increase in option volume or implied volatility can be an indication that large, informed ‘smart money’ players (the elephants) are placing bets on upcoming events or announcements. These announcements can often have a significant impact on the price of the underlying stock, as with important corporate earnings, or other news.

These “smart money” traders or “insiders” who have privileged information will try to act on this information before it becomes public knowledge. The trading of options allows these “well informed investors” to increase their leverage and enables them to maximize their gains without risking their identity.

So how can we, as retail investors, benefit from this knowledge?

A significant increase or abnormal fluctuation in the trading volume of a stock’s options and/or a substantial increase in the daily implied volatility of the stock’s options can be a precursor of a major movement of the respective underlying stock.

Sudden changes in options volume and implied volatility can be a tip off to potentially explosive moves in individual stocks. A move of great magnitude is almost always going to be fueled by news, but correct analysis of option order flow can alert one before the news is disseminated to the public.

Often this type of news strikes hard at the heart of a company’s future prospects for growth and profitability.

Examples of these types of news are the following:

1 Earnings substantially better or worse than Wall Street expectations
2 New product developments or breakthroughs
3 Mergers and acquisitions
4 Upgrades/Downgrades coverage by Wall Street Analysts
5 Media coverage
6 Products waiting for FDA approval or in clinical trials

And fairly often, this type of news is leaked. The people and organizations who know about this information will use it to their advantage. By looking for this unusual option order flow, traders can spot unique opportunities and bank big profits just by ‘following in the footsteps of elephants.’

There is more to this strategy than we will get into here, like making sure that there is not also abnormal options size on the opposite call / put options (usually just indicates hedging), but it still can be a very effective ‘clue’ to be aware of.

Since wagers are based on irregular movements in respective companies, this strategy’s performance is not dependent on interest rate stability, favorable stock market environment or any other market factor. This may present major profit opportunities, and returns can sometimes be far superior when compared to other strategies.

Conclusion: this trading strategy analyzes options data for the purpose of identifying significant increases (or abnormal fluctuations) in trading volume and volatility of the stock’s options as an indicator of movement and the timeliness of that movement in the underlying security. Options order flow analysis can be an indicator of “smart money” positioning, prior to publication of significant business announcements.

Another clue traders can look for are ‘block trades’ on the TOS (Time of Sales) reports. This is a related strategy, and does not necessarily indicate ‘insider’ buying, but can alert the astute trader to large institutional blocks of options being bought on either side of the underlying stock.

For example, if the average option trade size on a particular stock’s options is 5, 10, or 20 contracts, and you suddenly see large blocks of 200, 500 or 1000 contracts going into the close, then this is sometimes noteworthy and worth paying attention to the underlying stock.

 

November 4, 2007

I honestly don’t know when this madness will end, and the US equities will just take their 25% correction like a man.  Last week, the FOMC, as expected, cut both the fed funds and discount rate another 25 basis points, but also finally made some not quite subtle comments regarding the stifling energy and commodities prices that are being precipitated, at least in part, by the continuing devaluation of the US dollar.  Although the markets rallied on this news, the bill was paid the next day in the form of a near 400 point drop in the DOW, even after over $40 billion of liquidity was pumped into the system on that day.  The fallout from the irresponsible lending and borrowing continues as Citigroup’s CEO Chuck Prince seemingly will follow the lead of Merrill Lynch’s Stan O’Neal and take his formidable severance package and quietly sneak out the back door.

The stock gave up nearly $5 on Thursday and Friday to close at $37.73.

My assessment of the week from a fundamental standpoint was that most of the data was stronger than expected, oil closed at a ridiculous $95.93, and the dollar is at all time lows versus basically every  other currency.  The whispers of a pause, if not a hike, will shake these markets further, because the additional 25 basis point cut that is expected on December 11, which I alluded to in earlier articles, might not take place and the technical dynamics of the major averages are having very difficult times with these toppy levels.

However, the VIX remains curiously low (went out at 23.01 on Friday), and downside protection will be cheap to come by.  As a matter of fact, it is this author’s opinion that the time to get long the dollar could be right around the corner, and of course that would lead one to be short equities, energy, and commodities and long the VIX.  Although, that is predicated on the fact that the folks in Washington remember that it “is not the job of the FOMC to bail out the US equities markets”.

From an options standpoint, cheap volatility and substantial intraday price swings would lead most traders to consider long gamma positions, this strategy would been appropriate in the recent past.  For an explanation of this strategy, go to www.optionsuniversity.com.  In addition, subscribers to our membership site would have been made aware of a possible short term price reversal in MRK, based on a technical scenario called price/volume divergence.  From Wednesday’s close to Friday’s close, MRK was down over $2, with very little in the way of extrinsic price in the Nov 60 puts.  I would tend to expect some short term sideways activity forthcoming with little in the way of data or earnings to be expected.  However, geopolitical activity is always on the radar, as is now perhaps some more resignations in the financial sector???

 
Greg Wolfe, Options University

Recently, (October and November ‘03), the giant biotech Amgen (AMGN) came under some intense pressure, trading down about $12.00 before it found what appeared to be a decent level of support, and began to consolidate. At this level, anyone interested in going long Amgen at a discounted price would be advised to do so. Implied volatility was high coming off this precipitous drop, which caused premiums in the options to increase considerably.

This scenario can be a very attractive for covered call sellers or buy-writers. On Tuesday, December 2, 2003, Amgen was trading at $58.90, the December 60 call was trading at $1.30, and there were only two weeks left until expiration.

read more | digg story

Great article on some advanced strategies for trading options in the stock market.

read more | digg story

The fact that you are creating the covered call strategy (buy-write) by doing the vertical spread is very important to note. For margin purposes, the vertical spread will be margined at a much more favorable rate than the traditional buy-write because you do not own the actual stock and therefore do not have as much to lose.

read more | digg story

We have demonstrated how well options function in unison with a stock position. They enhance potential gains and provide profit protection. They enable us to manage specific risk in a single stock as well as an entire portfolio. But, as good as options are in conjunction with stocks, they can be even better when traded against each other.

There are many option strategies that do not involve the use of any security other than another option, like spreads, straddles and strangles, for example.

A spread involves the purchase of one option in conjunction with the sale of another option. There are many types of spreads. Some take advantage of stock movements while others are set up to take advantage of implied volatility movements. Some are even designed to take advantage of a stock staying still. There are vertical spreads, calendar or time spreads, diagonal spreads and ratio spreads just to name a few. Spreads can provide large percentage returns with low risk and can be entered into with small capital outlay.

Straddles involve the buying (long) or selling (short) of a call and a put (usually at-the-money) in the same stock, in the same expiration month, and the same strike.

Strangles involve the buying (long) or selling (short) of an out-of-the-money call and an out-of-the-money put in the same stock and in the same expiration month.

These are both trades in which you can take advantage of stock or volatility movements (in the case of being long) or lack of stock or volatility movements (in the case of being short) during the period of time until expiration. Both straddles and strangles are considered premium precision plays.

These trades are considered more advanced and sophisticated than the strategies previously discussed in this course. Certain spreads, such as 1 to 1 vertical spreads, can actually be less risky than some of the strategies discussed above, but spreads generally do have more variables to consider, and this makes them more difficult to trade.

The straddles and strangles sometimes involve much more risk and many more variables to take into consideration. So, these trades are considered very sophisticated and should not be entered into by untrained novices.

For this reason, we will not be covering these strategies in more detail here, but will be introducing them to you in our members’ area and in future releases – once you have had time to master your option basics.