Wall Street is not off to a good start in 2009. Year-to-date, the Dow Jones Industrial Average has dropped by almost 8%, the S&P 500 is down over 7% and the Nasdaq is down almost 4%.
One way investors can profit off of market sell-offs and increased volatility is with the use of options. An option gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. For equity options, the underlying instrument is usually a stock or an exchange-traded fund (ETF).
Options’ trading is simply a way to increase the use of leverage without having to put up a lot of capital. With options, it’s possible to make up to a lot more money on the same move in the underlying stock than if you bought the stock outright. Many investors use options as a leverage tool, but some also use options to hedge risk or for protection.
On the latest episode of CNBC’s new program “Options Action,” host Melissa Lee started the show with a discussion of the S&P 500 versus the Volatility Index (VIX). Lee explained that every time in the last six months that the S&P has hit 850 the VIX has retreated. However, on Friday the VIX spiked higher. Stacey Gilbert, chief options strategist for Susquehanna Capital Group, said there is a 15% probability that the S&P falls another 10% from current levels. Jim Iuorio, managing director of TJM Institutional Services, told viewers that the panic switch hasn’t flipped to 100% yet in the markets. Brian Stutland, president of Stutland Equities, said that traders are selling VIX futures as the market sells off, which could be an indicator of a bottom. “Contraction in volatility after a big down move is very positive,” he added.
Playing the SPY. Mike Khouw, senior trader at Cantor Fitzgerald, mentioned that retail investors should look to play the SPDR Trust (SPY) options. Gilbert pointed out that the premiums on the SPY options are too expensive. She said a better trade is to buy the SPY June 80 puts and sell the June 75 puts against it. Khouw said he likes the trade. Iuorio mentioned that he has the same type of options trade on for April and May.
Financial Calls. Lee moved the discussion to the options action in the financial sector. She said speculators were buying up the February 10 calls on the Financial Select Sector SPDR (XLF). A call option is an option to buy a stock at a specific price on or before a certain date. Khouw told viewers to buy the March 25 calls on JPMorgan Chase (JPM) and sell the March 30 calls, or March 17.50 calls against it to finance the trade. “I don’t like playing the banks, but if I did I would use JPMorgan and Goldman Sachs Group (GS),” Iuorio said.
Seasoned market players will often look at the volume on the call options for a specific stock as a sign that speculators are placing bullish bets. Increased call activity could forecast a future rise in the stock price. However, if a stock is trending down, the increased volume activity could be a hedge trade for a large institution that is shorting the stock.
Gold Put Spreads. Iuorio said he likes the action in gold over the banking sector. He recommended a put spread through buying the April 100 calls and selling the April 105 calls on the SPDR Gold Trust (GLD). Stutland said he loves this trade idea. Gilbert mentioned some gold stocks like Newmont Mining (NEM), Barrick Gold (ABX) and Gold Fields (GFI) are displaying some bullish action. “If gold goes higher these companies will do well,” she said.
Coach Calls. Lee brought up the increased bullish options activity in Coach (COH). Gilbert said there was a lot of call buying on February 15 and 17.50 calls and the March 17.50 calls. She explained that there was market chatter that someone might be interested in buying Coach. She recommended investors buy the May 15 calls and sell the May 20 calls to finance the trade. Khouw suggested just buying the same cheap call options that speculators are playing instead of putting on the call spread that Gilbert recommended.
Unusual Options Activity. Lee moved the discussion to the unusual options activity in Royal Caribbean Cruises (RCL). Khouw said there has been a ton of activity in both the stock and the options of Royal Caribbean and Carnival (CCL). He pointed out that Royal Caribbean is supposedly in violation of some of its debt covenants, so he recommended buying March 5 puts for 65 cents.
Unusual options activity can come in a variety of different forms. Traders may notice certain patterns in an option like an increase in volume or a spike higher (or lower) in the volatility of an option, with little corresponding action in the underlying stock price. These types of patterns often indicate that speculators are actively putting money to work as they bet on the future direction of a stock price.
Think of unusual options activity as a forensic footprint left behind by the so-called smart money on Wall Street. For example, if you notice heavy call buying on a stock, it could mean the smart money knows something you don’t and the stock is poised to move higher.
Check out the Stocks With Unusual Options Activity portfolio to discover some stocks that are seeing some unusual trading activity.
Pump Up The Volume
In the show’s “Pump up the Volume” segment, the traders focus on stocks that saw unusual options activity during the week. Lee said options activity on Procter & Gamble (PG) saw put activity that eclipsed three times the normal volume.
The traders took a look at trading Disney (DIS) ahead of their earnings report Tuesday afternoon. Lee explained that options traders are pricing in a 6% move with an upward bias. Ron Ianieri, chief market strategist at Options University, said Disney could report faltering numbers and he recommends playing the downside with a vertical spread. He told viewers to sell the February 20 calls and buy the February 22.50 calls. Khouw said he likes the trade for a bearish bet on Disney.
Final Call
Gilbert recommended a call spread on JPMorgan Chase (JPM). Iuorio said play gold with options and stay away from financials. Khouw told viewers to buy the SPDR Trust (SPY) March 80 puts and selling the March 73 puts two times against it to collect some premium.
Trading options can lead to some big profits for investors who are successful at it. Of course, before you trade options, educate yourself on the mechanics of this complex market.
Check out the Options Action Portfolio to learn about a few more stocks that are experiencing some unusual trading patterns.
Posted on Feb. 3, 2009
