Trading with the ‘Smart Money’

Trading lends itself to an analysis of data because there is so much data available.  Technicians plot prices (the most common data used).  But there are those who believe that volume tells the story.  Much data is available, and there is someone, somewhere who believes that he/she has found the ultimate investment technique – based on data analysis.  And perhaps that person has done exactly that.

One frequently discussed piece of data is trading volume.   For stocks, there's upside volume (paying the offer) and downside volume (selling the bid).

Options volume data offers more variety.  There's not only buy/sell volume but there's separate data available for puts and calls.  That allows the popular put/call ratio to be calculated.

Heavy volume often results is a rapid increase in option premium and  implied volatility.  (They come as a package; you can't have one without the other.) 

If you are into analyzing numbers, there are plenty of numbers available.

The point is that there's lots of data and some traders, analysts, journalists love to use volume data to forecast future stock price changes.

At times a surge in trading volume precedes a big price change.  The best example of this occurs when people with inside information buy huge quantities of options, choosing puts or calls, based on what they know.  Of course this is against the law and with today's technology, the perpetrators usually get caught. 

Many times this 'smart money'  – defined as money invested by experienced people; especially when they have inside information – is invested by stupid people, who are about to face big problems when caught trading on this inside scoop.  When this money enters the marketplace, the volume surge is predictive.  In other words, insider's information is accurate, and the stock moves accordingly – once the news is released. 

But this doesn't happens often enough to assume that an increase in volume has any significance.  If you always go along with a large volume increase, you will win on those rare occasions when the volume surge is the result of people who know something.  Most of the time there is no reason to assume anyone knows anything when you see a report of large trading volume in a specific option series (a single specific option) or class (all the puts or calls of a specific stock).

Recently there was a good discussion by Adam at the Daily Options Report about a surge (make that a tsunami) in call volume for two stocks.  It was all very innocent and involved an attempt to capture the dividend (a play that's not for individual investors – and that's why I have not mentioned it previously).

"The big trade Tuesday was massive call volume in Verizon and AT&T, particularly in the January in-the-money (ITM) options that basically carry a 100 delta (i.e., they are virtually stock). In fact, volume was so high that it dwarfed the pre-existing open interest in both names.

To add even more intrigue, both names found themselves all over the news wires thanks to Google unveiling the new Nexus One smartphone.

At first glance, you might be thinking this looks like smart money loading up on calls.

Nope. It's just some dividend-capture plays."

But, that volume might have made speculators to believe some monumental deal was about to be announced or that the entire industry was about to get some outstanding news.  As is often the case, the volume meant absolutely nothing.

Another example occurs when a stock owner decides to write covered calls or buy some puts for protection (or perhaps do both by trading a collar).  These large trades have no predictive power because the person making the trade is just taking insurance on an already-existing investment.

Don't follow the action, hoping the big trade is being made by 'smart money.'


7 Responses to Trading with the ‘Smart Money’

  1. Steve 01/13/2010 at 6:22 AM #

    I’m a regular reader of your blog and have read and learned much from your book.
    On a slightly different tack from your usual fare, I’d like your comments on the following ideas.
    Apart from selling options for income, I gather further income from a group of “high quality” dividend paying stocks. I consider these a conservative, core holding.
    Recently, I’ve been considering replacing these core stocks with long term short puts on the same stocks.
    As an example, take JNJ. I like the stock, because although it yields only about 3.1% in dividends, it consistently raises the dividend by 10% per year or more. A nice recipe for a long term hold.
    But what about this idea? I recently sold a Jan 2011 65 strike put for $6.35. This seems to offer two outcomes:
    – If the stock closes above $65 next January my annual “yield” will be 9.7% compared to the 3.1% on offer to the long stock holder. It is likely that I may buy back the option early (due to stock increase and/or time value decrease) for an enhanced annual return.
    – If the stock closes below $65 next January, I still get the 9.7% yield and I own the stock at $58.65, a discount of almost 10% on the current price.
    So far, so sensible.
    As my account is a margin account, the actual funds committed to this sale are about $1850 under RegT margin rules giving an annualised return on margin of 34%!
    Going on to the ridiculous:
    My margin account is a PM (Portfolio Margin) account. The actual margin for this short option is $690. Giving an annualised return on PM of 92%.
    Leaving aside these silly, margin figures, what is your opinion of the option strategy as an alternative to holding the core stocks?

  2. Mark Wolfinger 01/13/2010 at 9:49 AM #

    1) I like the idea very much
    2) your major risk is seeing a substantial increase in the price of the stock. Your gains are limited with option sales. But that’s a risk I would take, and apparently so would you
    3) It’s ok to calculate returns on Reg T margin, but ONLY if you already own stock using margin. If you pay for stocks in full, with cash, then it’s not right to suddenly compare gains by using margin.
    4) Don’t do any calculations with portfolio margin.
    5)Don’t force these trades. Higher quality, dividend-paying stocks may have option premium that is too low.
    It is nice to get a higher yield, but you do have to give up the potential price increase. Just be certain you are satisfied with the premium collected.

  3. Steve 01/13/2010 at 11:07 AM #

    Thanks for the reply.
    I’m quite happy to forego any stock gain for this part of my portfolio. I was quite happy to sit for the rest of my life collecting 3% dividends (increasing by ~10% each year), so 9%+ sounds just fine! (34% return on margin seems even better…)
    Keep up the good work – you are a great educator.

  4. najdorf 01/14/2010 at 12:19 PM #

    Put-selling is a nice example of a strategy that works really well until it doesn’t. If you think there’s no risk of permanent impairment of a given stock’s value, you’re wrong – stocks are all risky. Today you’d be happy to buy Stock X at a 10% discount to market prices, but you might feel very different if it gets put to you at a premium and you’re faced with either closing out the position at a loss or holding a stock you no longer like as much due to changed circumstances. The decision to go long the stock if it declines simply because you are short puts is a huge sunk-cost fallacy. If you like the stock, buy it now or invest in safe assets until it becomes cheap enough to buy.
    Furthermore you need to calculate how much margin you would have to hold as the share price declined, not just the initial margin. If you don’t have the cash you may get knocked out of some positions that would have been fine if you could hold on. You’re taking enormous risk in exchange for a 9% yield.
    In a theoretical sense your expected outcome from option-trading is negative (due to transaction costs and the zero-sum nature of options) unless you have an edge on the average options trader. Do you think the average options trader just hasn’t realized that he can get some money by selling puts? Do you think you know something that people buying puts for protection don’t know?

  5. Mark Wolfinger 01/14/2010 at 12:31 PM #

    Steve has already decided to take the risk of stock ownership. Thus, your warnings about risk are being directed to the wrong person.
    Your suggestion that it might look okay today to buy stocks at a 9% discount to current prices, but that it may not look so good later – is true. It’s important to consider that when selling naked puts. But Steve ALREADY OWNS THE STOCKS, WANTS TO OWN THE STOCKS, AND IS NOT CONCERNED ABOUT RISK – for this portion of his portfolio.
    What you fail to comprehend about the average trader is that’s the person who is UNWILLING to sacrifice any future profits. That’s the reason your average trader does not sell puts. He/she buys stock, hoping for an upside miracle.
    Steve is above that. He is willingly trading upside potential for cash. There is nothing wrong with that decision.
    Margin? Margin? Steve currently owns these stocks. If he is assigned an exercise notice, he is right back were he is now. No margin problems. None.
    If commissions are a problem, you are using the wrong broker.
    Options are NOT a zero sum game. That is a short-sighted opinion. If I sell a put options and WILLINGLY sacrifice the upside, then I have lost NOTHING when the stock surges. NOTHING. I sold that upside, agreed to sell it. Loved selling it. Was paid to sell it. How in the world can you think that I lost money because someone else made a profit? You are quick to point out fallacies. Yours is the fallacious argument.
    Your warnings are well intentioned – but you want to direct them to people who sell naked puts as an initial trade, not to Steve (nor to me).
    Thanks for posting

  6. Roger 01/17/2010 at 9:57 PM #

    1. Regarding your answer to najdorf’s Q about Steve not selling naked puts as an initial trade, maybe I’m misunderstanding a definition. While Steve already owns JNJ stock and is willing to own more if the puts he sold get assigned, don’t his sold puts qualify as naked since he hasn’t bought a lower strike price put to cover in case JNJ’s price blows past the strike price of his sold puts?
    2. “Margin? Steve currently owns these stocks. If he is assigned an exercise notice, he is right back were he is now.” Which means he will own even more stock but the margin situation hasn’t changed because his broker at the time of the put sale insisted on appropriate margin to cover the possibility of future assignment, right?
    Thanks Mark.

  7. Mark Wolfinger 01/17/2010 at 10:23 PM #

    Hi Roger,
    1) Steve plans to SELL his stock. He does no need for a lower strike put.
    Steve plans to sell naked puts INSTEAD of owning stock. Not in addition to owning stock.
    Those two trades are equivalent to selling a call.
    2) As noted, he will not own more. He will indeed be right back to his current position – if he is assigned an exercise notice on those puts.
    But, yes you are right. If he were not planning to sell the stock, then the broker would require extra margin at the time the puts are sold.
    However, not everyone trades cash-secured puts. The margin requirement for a naked put is less than than when owning stock. Thus, more margin would be required on assignment – if and only if – he chose not to be cash-secured.