Would you believe smart money bet against the market last week…before the drop?
While everyone else bought calls, these fat cats took the other side of the trade.
And man did they get paid last week!
You can deploy the same strategies as these titans.
Heck, I SELL OPTIONS all the time in my Total Alpha Portfolio.
Before you start running naked through the option chain, we need to discuss what’s causing this massive shift in options trading.
To help with that, I brought you an exclusive interview with Larry McDonald of the Bear Trap’s Report.
His insights validated my analysis.
You need to watch this.
Now, I know some of the terms and ideas he tossed around might be a little confusing.
So, let me break down his ideas into bite-sized pieces.
Option volume explosion
Two things happened during the pandemic.
First, trading volume increased as investors rushed to buy up insurance to hedge their positions.
Second, millions of people locked themselves indoors with nothing to do.
The growth in option volume over the last six months has been incredible.
To give you an idea, in January of 2020, the Chicago Board of Exchange counted 23.68 million option contracts traded worth just under $1 trillion.
In July, we saw 27.1 million contracts traded for a value of $15.8 trillion, and August saw 28.6 million contracts trade for $17.25 trillion.
A good chunk of this has been retail traders entering the market. But we’ve also seen investors skeptical of the rally.
Instead, they buy calls on stocks rather than owning the equity outright as a way to reduce their risk.
Recently, several news outlets (and even Larry) pointed to Japanese Softbank driving up prices on tech stocks through huge amounts of call buying.
Now, let me explain how this creates stronger rallies and selloffs.
A while ago, I wrote about the role of market makers. These players make it possible for traders to buy and sell seamlessly.
Think of them as a warehouse of stock inventory. They facilitate transactions for you, me, and the big guys.
At the same time, they manage their inventory levels so they always have enough in stock.
With options, their role is a bit different.
Every time someone buys a call option, they sell it to them. That means the option buyer has the right to buy 100 shares of stock per contract.
To offset this risk, they go out and buy the stock so that they have inventory to meet contract obligations.
For put options, they need to sell or short stock to offset the obligation of a put contract – the right for the option buyer to sell shares to the market maker.
The amount they hedge depends on how far out-of-the-money the options are. Calls that are farther out-of-the-money require less stock as an offset compared to ones at-the-money.
And, as a stock’s price increases, so does the need for the market maker to hedge.
This creates a vicious cycle of people buying call options and then market makers buying stock to offset the contracts.
But like everything else, it can get out of hand, and that’s where the smart money strategies come in.
Selling into buyers
As Larry noted, the implied volatility of Apple rose alongside the stock.
Implied volatility is the market’s expectation for a percentage move in shares on an annualized basis. Think of it as market demand for that call or put option.
Normally, implied volatility rises when a stock goes down and declines when they go up.
What I saw, along with the smart money, was implied volatility going up as stocks like Apple went higher.
How do I interpret this?
I take it as a sign that fear of missing out (FOMO) grabbed retail traders and told them to buy call options.
This surge in implied volatility drove an increase in Apple call option prices (AKA premium).
Now, experienced option traders know that implied volatility is mean-reverting. That means when it extends too far one way or the other, it often moves back to the averages.
And this is what creates the opportunity for option sellers.
Option selling strategies
In order to capture this edge, I need to be an option seller.
There are multiple ways to do this.
My favorite for this situation is a call credit spread.
A call credit spread is a risk and reward defined trade for option sellers.
When I initiate the trade, I receive a credit. This is the maximum profit I can make.
However, I can also close the trade early and keep a portion of this money.
Let me use an example with Apple.
- Jeff wants to sell a call credit spread on Apple which is trading at $114 a share
- He sells the $120 call strike on Apple that expires in 3 weeks for $4.55
- Then, he buys the $125 call strike on Apple for the same expiration for $3.05
- His net credit received is: $4.50 – $3.00 = $1.50 x 100 shares = $150 per spread
- Jeff keeps this entire credit if Apple closes at or below the lower strike ($120) on the expiration date
- His maximum potential loss is the difference between the strike prices less the money he received up front
- Max potential loss = $125 – $120 – $1.50 = $3.50 x 100 shares = $350 per spread
Here’s what’s neat about this trade.
I can take it off early and keep a portion of the profits, locking in gains early (and I often do).
But here’s the best part.
Any decreases in implied volatility work in my favor!
Note: This is only true for spreads out-of-the-money
So, even if the stock goes nowhere, but the implied volatility declines, I get the benefit!
Learning options trading
I know that some of you may not be comfortable selling options.
Or maybe this all seems overwhelming.
No worries, I’ve got you.
This primer sets you up with some of my favorite trading techniques and strategies that apply to any style of trading at any experience level.
I want to make sure you have the best information to achieve your goals in the market.
So come check it out.