Options: Does ‘Active’ Mean ‘Profitable’?

by Lawrence Meyers | August 29, 2012 11:20 am

Options: Does ‘Active’ Mean ‘Profitable’?

One thing that option investors often look at is which options are experiencing the highest trading volume. But there are different theories on the interpretation of high-volume options trading.

One that carries a lot of weight with me is that institutions are placing speculative bets on the movement of a given stock or index. Since institutions are just like traders in the general public, it stands to follow that because they are able to trade in large volumes, getting on the correct side of a trade for even a few pennies could result in a very large profit. The other angle that I buy into is that options are used to hedge positions, so certain stocks with earnings approaching might see increased option volume.

The question for you, the retail investor, is whether you can profit from this information.

Let’s take a look at the five most active option trades as of the writing of this article (Tuesday, Aug. 28), and determine how these plays stack up against other strategies.

SPY Nov 130 Put

This option is a bet that the SPDR S&P 500 ETF (NYSE:SPY[1]) will be under $130 at November expiration. The underlying was trading at $141.50, and you would be paying $1.66. So you would profit if the ETF falls below $128.34, which means the S&P 500 would have to fall about 10% in the next two months.

This seems to me to be a bet on the election results, very likely on an Obama win. Given that the election is too close to call right now, I think this is probably a hedge. If you want to protect your portfolio should Obama win and the market not take kindly to it, it’s a reasonable price to pay for that protection. Of course, since there are two parties on every trade, somebody else is happy to receive $166 per contract to have the stock put to him at that price.

The problem I have with portfolio hedges using options: How much potential upside are you willing to give up to protect how much of your portfolio if the trade goes wrong? So I’d rather try to generate income from covered calls on long-term positions, which is a hedge in its own way.

HD Jan 35 Call

This option is a bet that Home Depot (NYSE:HD[2]) will be over $35 at January expiration, and was trading at $21.66, which probably seems odd since the stock itself was at $56.67.

The purpose of a deep-in-the-money call like this is protection against any movement in the stock while collecting premium. I’m guessing that since the extrinsic value of the option is only a penny, this is an institutional trade not worth your time.

WFT Nov 15 Call

This option looks very specific to the company, betting that Weatherford International (NYSE:WFT[3]) may or may not break $15 come November. The option was trading at 28 cents as of Tuesday.

It looks to me like Weatherford is dealing with accounting and tax reporting issues, not to mention possible dealings with blacklisted countries. Still, the stock was at $12.24 and by all financial metrics is grossly undervalued. This says to me that calls are being sold because speculators believe these issues aren’t going to be resolved by November, so why not capture a little premium? Call buyers speculate that the market will reward a great earnings report or that the issues will resolve favorably by then. Either way, this is one of those trades where you must trade in volume for little premium. Move on.

IWM Sep 74 Put

This concerns the popular iShares Russell 2000 Index ETF (NYSE:IWM[4]), which was trading at $81.35, and the option at 19 cents. This is the larger index analog to the S&P trade above. Again, it appears to be a hedge against a 10% drop in the index, but the expiration date is not likely election-related.

I suspect this is standard operating procedure for high-net-worth money managers and institutions against their own portfolios. Cheap insurance for uncertain economic times. Again, unless you fall into one of these categories, I don’t see much point.

XLE Sep 63 Put

Here we have an energy play, hedging against a drop in the Select Sector Energy SPDR (NYSE:XLE[5]) from $72.10 to $63, in exchange for a mere 13-cent payment. This probably is a hedge against institutional energy holdings, as the XLE is almost entirely made up of producer-explorers like Exxon Mobil (NYSE:XOM[6]), Chevron (NYSE:CVX[7]) and Schlumberger (NYSE:SLB[8]). Because the price of oil is volatile, and energy holdings tend to make up large portions of income-based portfolios, this is cheap insurance against a big fall in oil prices. No purpose here for retail investors.

Bottom Line

So what we see, with today’s most actives, is that they aren’t really the kinds of trades suitable for retail investors. The one exception might be a hedge against an Obama win in November, which I see as being more likely to tank the market. Otherwise, I’ve written about other option strategies[9] that I think will play better with retail investors.

As of this writing, Lawrence Meyers[10] did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc.[11], which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com[12]. He also has written two books[13] and blogs about public policy[14], journalistic integrity[15], popular culture[16] and world affairs[17].

Endnotes:
  1. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  2. HD: http://studio-5.financialcontent.com/investplace/quote?Symbol=HD
  3. WFT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WFT
  4. IWM: http://studio-5.financialcontent.com/investplace/quote?Symbol=IWM
  5. XLE: http://studio-5.financialcontent.com/investplace/quote?Symbol=XLE
  6. XOM: http://studio-5.financialcontent.com/investplace/quote?Symbol=XOM
  7. CVX: http://studio-5.financialcontent.com/investplace/quote?Symbol=CVX
  8. SLB: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLB
  9. written about other option strategies: http://investorplace.com/2011/11/4-tips-for-becoming-a-successful-covered-call-seller/
  10. Lawrence Meyers: mailto:pdlcapital66@gmail.com
  11. PDL Capital, Inc.: http://www.pdlcapital.com/
  12. SeekingAlpha.com: http://seekingalpha.com/author/larry-meyers/articles
  13. written two books: http://investorplace.com/author/lawrence-meyers/
  14. public policy: http://biggovernment.com/author/lmeyers/
  15. journalistic integrity: http://bigjournalism.com/author/lmeyers/
  16. popular culture: http://bighollywood.breitbart.com/author/lmeyers/
  17. world affairs: http://bigpeace.com/author/lmeyers/

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