Option Premium - Smart Money or Dumb?

Option Trading Topic: Option Premium: Smart Money or Dumb?

Dear Options Trading FAQ:

Help, I get confused when thinking about options trading! In some recent letters you say to look at the option premiums and go contrary to what is popular. Then, you go ahead and give other examples where you laud call option buying in certain stocks as "informed". Which is it, oh Option Guru?

For example, if the call options are priced higher than the put options, I myself would think it to be a bullish signal, but from your example :

>Here is an example from today (01/04/96):
>The SPX is 620. The Jan 610 put option is 1 5/8. The mirror-
>image call option, the Jan 630 is 1 7/8. The call here is
>actually priced higher than the put!! Quite bearish.

How is it *quite bearish*?? I would think since there are equal numbers of people thinking the equity price will go up or down, there is equal chance of it doing so, no?

Can't Get Contrary on Option Trading

Dear Can't Get Rich Trading Options If You Can't Get Contrary:

Let me start with the example you quoted. The analysis went in my mind as follows: "Ever since the Crash, the SPX Put option premiums have been highly valued (needed by institutional players as insurance). In a "normal" situation they will be bid higher than their respective calls. So I see that in this case where the calls are more expensive than the puts, something unusual is going on. In fact, my usual trigger level is when the calls and puts trade at the same price - here we have exceeded that. There is a bullish frenzy present that cannot last. The puts are undervalued and the calls overvalued. The imbalance in sentiment must swing back the other way - What would cause that? Why, a market downswing. So go bearish."

That turned out to be precisely right as market followers know. This thinking was predicated on the assumption that the SPX option players represented "dumb" money. That brings me to your initial question, How to recognize the option sentiment as right or wrong.

Traditionally, the bulk of option speculators are considered wrong-way thinkers. Many time-honored technical indicators are contrarily based on the action of option traders (Put/Call Ratio, Dollar-Weighted Put/Call, Premium Ratio, etc.). I would go along with that when it comes to large bodies of option speculators (i.e., index options as a whole, or total equity option put/call ratios).

When looked at in total, one should consider the sentiment revealed as possibly wrong-way. Mind you, the crowd is allowed to be absolutely right at times (as many "too-early bears" in this current market can attest to - that means you, Mr. Granville and Mr. Prechter!), but in the whole, it is not in the nature of any market to let the herd make unlimited tons of cash.

The work of Bernie Schaeffer, Larry McMillan, and others have shown, however, that in specific instances, "smart" (and I mean VERY SMART) money can be seen moving into certain options. Careful tracking of money flows and volume swells in equity options can tip one off to the placement of "smart" money. This "informed" option activity (in the absence of news) alerts the savvy option trader to upcoming news in the stock. Recent examples of this include the huge inflation of option premium in the Loral calls the night before the takeover announcement. That case was dramatic as the price of the options continued to RISE in the face of a downticking stock. Another example is the jump in the options of Roberts Pharmaceuticals. For days the call options acted unusually, then the stock jumped 4 points in a day. Subsequently, it was announced that there may be an important drug approval coming up.

Particulars aside, watching the action in specific equity options will forecast the crucial moves in the stock. Here we must consider unusual option activity (a jump in implied volatility, a huge premium in price over the theoretical value, a swell in put or call volume), in the absence of news, as an indication of what the insiders are doing. There is hardly ever any "big news event" in a stock that occurs in isolation. The option activity will tip you off first. There seem to be no secrets on Wall Street (Psst, Harriet, Now you know I'm not supposed to say anything, but your dad better buy some calls on my company by next Tuesday...)
Sometimes it is not at all easy to discern if option activity is "smart" and should be emulated, but the concept is valid. If you concentrate on stocks whose options suggest something is cooking, you start on a higher plane than the usual trader. Let the options work for you. Make sure you keep an ear open to what they are telling you.

More in future columns on advanced techniques on reading option premiums (divergences, non-confirmations, etc.)

PS. Often times, with "outrageous" premiums extant, the savvy option trader will play the stock itself rather than join the mania in the options. If you are wrong, there is a good chance for another go at it, unlike with the overpriced options where there is often no second chance.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Pricing, Options Strategy

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