Category Archives: Options

Big Money Is Betting On A Big Move In Financials

I always find it fascinating to see what kind of big trades are being made in the options markets.  Some of the smartest strategists in the world use options markets as their playground, so generally speaking, you can assume a lot of research went into these blockbuster type trades.

It’s also interesting to guess what the goal of a particular block trade is.  Of course, we can never know for sure.  A trade could be a hedge or a speculative bet.  It could be part of a much larger strategy with multiple pieces in different markets and asset classes.  Unless you’re talking something like a covered call (which is self-contained), we can only make an educated guess as to what a trade’s purpose is.

Nevertheless, we can often glean important information about an asset or asset class from associated options action.   For example, when you see a large straddle being purchased, it can be a useful indicator that there’s going to be an increase in volatility or movement in the underlying instrument.

A (long) straddle is an options strategy where the trader buys a call and put at the same strike in the same expiration in an underlying asset.  By purchasing both the call and put, the trader is not reliant on the asset moving just up or just down.  The straddle allows the buyer to make money in either direction, as long as it has moved far enough from the strike.

Essentially, going long a straddle is a bet on volatility.  A buyer doesn’t have to be correct about a direction, just that the stock/ETF/etc. is going to be at a different spot than it is now.  (It’s typical for straddles to be purchased at the at-the-money price.)  Professionals will often hedge their straddle when it moves using stock.  However, there’s no reason you can’t just trade the straddle and let it ride.

Just this week, an interesting straddle hit my block trade screener which I believe is worth a second look…

A well-funded trader purchased the 28 strike January 2019 straddle (28 call plus 28 put) in the Financial Sector SPDR ETF (NYSE: XLF) for $2.51 per straddle with the stock at $27.75.  XLF is the most popular ETF for trading the financial sector.  It covers banks, insurance companies, investment companies, and a few other related industries.

This particular straddle shows that the trader likely is expecting financials to be in a very different spot in the next five months.  Of course a lot can happen in 5 months, and there’s a significant election day during that period where control of Congress will be decided.

At $2.51 per straddle, this trade will break even above $30.51 or below $25.49.  At expiration, if XLF is between those prices, the trade will lose money – although max risked is just the $2.51 spent on premium.

Still, the straddle was bought 5,000 times, which costs over $1.2 million dollars.  That’s no small amount being risked.  On the other hand, the trade will generate $500,000 in profit for every dollar above or below the breakeven points.

Besides elections, there’s also plenty of economic news and data expected in the coming months.  There will also be a handful of widely followed FOMC meetings where rate increases could occur.  In other words, there are a multitude of potential catalysts for an increase in volatility in the financial sector.

If you agree that XLF could be on the move for the remainder of the year, then this isn’t a bad way to position yourself.  $2.51 for a straddle is not an unreasonable price to pay with five months of time left until expiration.   Most importantly, you don’t have to pick a direction.

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Source: Investors Alley

Making Money Off Chipmaker Stocks With Surging Prices

In the world of graphics cards, also known as GPUs, the US market is dominated by two major players. You’ve probably heard of both of these companies as their stocks are often in the news. The bigger of the two is Nvidia(NASDAQ: NVDA), but Advanced Micro Devices (NASDAQ: AMD) and their Radeon GPUs have plenty of traction in the industry.

NVDA and AMD are big players in the chip-making industry as powerful GPUs have become normal components in most desktops and many laptop computers. While potent GPUs are a perquisite for any serious video gamers, even casual games can benefit from high-end graphics cards. And let’s not forget, GPUs are the devices of choice for mining cryptocurrencies.

Even without the cryptocurrency craze, NVDA and AMD would still be doing quite well as gaming becomes a bigger part of our everyday lives. The whole e-sports industry is still relatively new and gaining popularity rapidly.

NVDA is a $150 billion company that’s seen over 30% gains this year in its share price. Meanwhile, AMD is a much smaller $18 billion company, but the stock is up 89% this year. The stock price jumped about 15% on very solid earnings just recently.

NVDA may have settled into a range, but AMD is still in breakout mode. So, how high can the stock go? Is it worth buying despite the huge year it’s already had?

To help answer these questions, I prefer to look at the options market. Here’s what I found…

A highly capitalized trader recently sold 9,000 January 2019 AMD calls at the 25 strike for $0.91 per contract (with the stock trading at $19.05). The trader is collecting over $450,000 on the calls but is exposed to unlimited upside risk above $25.91. Any price below $25 at January expiration and the entire amount of premium is kept.

So what’s going on here? $450,000 is a lot of money, but is it enough in return for unlimited risk? For every dollar the stock moves above roughly $26, the position loses $900,000. That’s obviously a heavy amount to risk, especially for a stock which has already moved up 89% this year.

The thing is, this trade is very likely being used as an overwrite on existing long AMD stock. The trader could already hold AMD shares and feels the shares won’t climb above $25 before next year. In that case, the call selling is being used to generate extra income on the long shares while still maintaining upside potential up to $25.

We could easily emulate this trade by purchasing shares and selling the same calls against them (1 call sold for every 100 shares purchased). In fact, I think that’s pretty solid covered call. You’d be earning 4.8% yield for about a 5-month period, with a chance to make an extra 31% if the stock keeps climbing.

While AMD has had a really nice run this year, it’s also probably not going to shoot above $25 anytime soon. A covered call could be a great way to capture a decent yield without giving up most of you upside potential.

If covered calls aren’t your thing, you could also make a similar trade to the short call trade by selling a call spread. The January 25-30 call credit spread (selling the 25, buying the 30) has about a $0.60 credit while limiting your risk to $4.40 if the stock skyrockets higher.

Personally, I like the covered call trade quite a bit better than the credit spread. However, the important takeaway here is don’t ever short calls by themselves. Either use stocks or other options as a hedge. Even pros rarely short calls without some kind of protection.

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Source: Investors Alley 

How To Bet Big On Banking With Options

Often make the argument that trading options is superior to trading stocks. Now, I’m not talking about investing in stocks… if your goal is to collect dividends, you obviously need to buy stocks. But when it comes to trading (short to medium-term holding periods) options are almost always the better choice.

Generally, options traders will point to the built-in leverage of using options and the ease of access to underlying assets which would otherwise be difficult to afford. However, I believe the most important benefit to options is their flexibility. Most significantly, being able to tightly define your risk parameters for any given trade is a huge advantage to using options versus stocks.

Because you can you can buy and sell both calls and puts, it opens up a massive variety of options combinations (what we generally refer to as spreads). Throw in combinations of options and stocks (covered calls, delta neutral trading, etc.), and you’ve got nearly unlimited choices.

One type of spread you’ll often see professional traders use is the ratio spread, or the ratio backspread, to be more specific. This type of trade essentially has too much risk involved to be used by most casual traders. A standard backspread consists of buying an option near the money (call or put) and selling two options in the same expiration at a higher (call) or lower (put) strike.

This type of spread is very popular because it greatly reduces the cost of the trade by selling two of the farther away options. On the other hand, the double short strike means there’s unlimited risk if the underlying asset prices moves through the strike. That’s why this is a common trade among pros but generally avoided by the casual options trader.

Nevertheless, you can still glean a lot of information from large block backspreads which hit the tape. (There are also ways to roughly emulate the trade without taking on the same amount of risk.) In fact, a very interesting ratio backspread hit my screener this past week which provides a moderately bullish take on Morgan Stanley (NYSE: MS).

The spread expires in October and was put on with MS trading at $50.72. The trader purchased 15,000 of the October 52.5 calls while selling 30,000 of the 57.5 calls. Selling double of the higher strike reduced the total cost of the spread to just $0.97.

By reducing the spread cost under $1, the trader has pushed the potential return up to $4.03 or 415% gains, with breakeven at $53.47. The spread buyer also is only risking $0.97 if MS stays below the breakeven point. However, there is considerable risk above $57.5… $1.5 million for every dollar the stock moves above that point.

Keep in mind, the trader is spending almost $1.5 million to place the trade (and stands to gain over $6 million if MS closes at $57.5 on October expiration). That’s a lot of money to put down on a three-month trade. As such, there’s clearly a strong opinion – backed by capital – that MS is going higher, but not to the moon, by October.

Let’s say you like this trade, but don’t want to expose yourself to the upside risk (or margin requirement). You can simply turn the spread into a standard vertical spread and pay $1.20 instead of $0.97.  It’s a reasonably close price to the backspread detailed above without all the risk.

So why would someone want to save just $0.23 on a spread if it comes with all that additional upside risk? First off, the strategist clearly believes MS isn’t going higher than $57.5 by October. Moreover, he or she could easily hedge the position with shares (or possibly already has done so). Finally, $0.23 doesn’t seem like a lot if you’re doing a 5-lot, but when you’re doing 15,000… well, it makes a big difference ($345,000 to be exact).

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How to Make A 186% Return on Video Games

Typically, when growth in the video game industry is discussed, it’s all about mobile gaming growth. After all, playing games on smartphones and tablets has been where most of the action has been in recent years, at least in terms of investing.

While casual gamers may still be driving plenty of business in mobile gaming, there’s still ample opportunity in more traditional gaming platforms, such as consoles and PCs. In fact, these traditional platforms may be even more important looking forward as AR/VR (augmented reality/virtual reality) games become more popular (and accessible).

One of the biggest players in the video game industry is Electronic Arts (NASDAQ: EA). EA is mostly known for its big label games, particular sports games and first-person shooters. Just last week, EA posted earnings and had a pretty substantial share price decline after issuing lower than expected guidance.

As you can see from the chart, EA stock dropped something like 6% the day after its earnings miss. However, the stock was having a great year up to that point and probably had become overvalued. The drop in share price may have been exactly the entry point some investors were waiting for.

First off, EA has several big games yet to come out this year which could boost revenue and earnings more than expected. I already mentioned the long-term potential of video games as AR/VR tech becomes better and cheaper. And then there’s the whole e-sports industry. Playing games competitively is an industry that’s growing like crazy and there’s a ton of money to be made in that arena, so to speak.

Here’s the thing…

A size option trader apparently agrees with me and purchased a massive call spread expiring in January of 2019. With EA stock at $132, the trader bought roughly 11,000 January 135 calls while selling the 155 calls for a total debit of $7. That means the trader spent over $8 million on the trade. Clearly, he or she if very bullish on EA over the next half year.

With $7 paid in premium, the breakeven point for the spread is at $142. That same premium is the max loss for the trade. Max gain is at a point anywhere above $155 at expiration, slightly higher than where the stock was before the earnings miss. Max gain is $13, or $14.3 million in dollar terms… that’s also a return of 186%.

I think this a decent trade to emulate. EA may not recover for a few months, but has several potential catalysts which could send the stock higher down the road. The price of the spread is not cheap, but 186% return potential and six months of time is reasonable for the cost.

If you like the trade but want to reduce your costs somewhat, you can narrow the spread. For instance, the January 135-145 call spread only costs $4 but lowers your max gain to $6. You can also pick an expiration which is closer, but I think EA may need the extra time to recover.

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Source: Investors Alley 

Is The Housing Market About To Hit A Top?

I don’t spend a lot of time writing about real estate in this space. It’s not that it isn’t important, in fact it’s quite the opposite. Of all the sectors most impacted by a change in interest rates, real estate is at the top of the list.

However, I just don’t find real estate that interesting compared to options trading. Housing prices tend to be slow moving, and unlike options trading, there just isn’t a lot of action involved with investing in the real estate market.  However, what if we combined the two areas… real estate and options trading? Now we’re talking about a topic I can relate to.

Of course, we can’t trade options on individual mortgages – and derivative trading on groups of mortgages is generally an OTC market limited to institutions. (Let’s not even mention that derivative trading on mortgages is a big reason why we had the financial crisis of 2008-2009.)

Fortunately, ETFs have emerged which allow investors and traders to get easily involved with real estate and mortgages. REITs tend to focus more on the mortgage side of things, while real estate ETFs often invest in stocks such as homebuilders and storage companies, as well as REITs.

Probably the most popular real estate ETF is iShares Dow Jones US Real Estate ETF (NYSE: IYR). IYR trades over 8 million shares a day on average and almost 20,000 options. As you can see from the chart, IYR has done very well the last few months (in line with the overall real estate market).

However, could real estate – especially housing prices – be in trouble in the coming months? Higher interest rates generally slow or stall the increase in housing prices (due to more expensive mortgages). Are expected rate increases going to derail the bull market in housing?

Let’s look at the options market for clues…

A large trade in IYR last week could suggest the real estate sector could take a downturn by the beginning of 2019. Or, perhaps a big investor is hedging his or her exposure to real estate. Either way, it’s worth paying attention to this trade.

More specifically, the trader bought a large put spread in January 2019 options with IYR at $80.60. The trader spent $1.15 to buy the 72-77 put spread (buying the 77 strike, selling the 72) strike a total of 15,000 times for a cost of $1.7 million. Max loss on a debit spread like this is simply the premium paid, aka the cost of the spread.

The breakeven for the trade is at $75.85 (77 long strike minus the cost of trade or $1.15). Max gain is at $72 or below by expiration and is the spread width (5) minus the cost of $1.15, or $3.85. In total dollar terms, the trader can make $5.8 million on the trade.

Whether this is a hedge against a long position or a bet that IYR is going lower, it is quite a lot to spend. Someone is, at the very least, concerned that IYR could lose 10% by early next year. That would be a pretty sizeable down move in the real estate market. If you have similar concerns or believe housing prices are going to peak in the next few months, this is a reasonable way to get almost six months of time for the thesis to play out.

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Source: Investors Alley

Are Options Traders Telling Us To Stay Away From Emerging Markets?

If you’ve been reading my articles regularly, you’ll know that I spend a lot of time talking about block trades.  These are the huge trades that show up on your options volume screeners, typically in increments of 1,000 or bigger.  They can be unusual volume in a normally lightly traded name, or they may be very big trades which occur in high volume names (such as index ETFs).

Options analysts like to look at block trades to see where the action is.  Usually very big trades are executed by traders with abundant capital.  Of course, lots of capital usually means access to copious amounts of research as well.  In other words, block trades are often done by people who have very good information.

Many times, the reasons behind these really big trades are easy to figure out.  Hey, someone bought 20,000 calls in Apple (NASDAQ: AAPL), it’s probably going up!  Or, sheesh, someone bought 50,000 puts in SPDR S&P 500 ETF (NYSE: SPY), it’s probably a hedge against a correction!

Other times, trying to figure out the purpose of a block trade can be a puzzle.  Sometimes, you never know what the traders are trying to accomplish.  It’s not like we are seeing the actual trading books of these traders… just one big trade at a particular point in time.

Still, there is a lot that can be gleaned from watching block trades, especially in stocks and ETFs which don’t trade that often.  They may give you an idea of where the underlying asset is headed or if volatility is going to pick up, among other things.

Here’s a very interesting block trade I came across this week…

The trade involved the purchase of over 20,000 puts on Invesco Emerging Markets Sovereign Debt ETF (NYSE: PCY).  Now, an emerging market debt fund may not sound all that interesting to you, but there are some very unusual factors to consider regarding this trade.

First off, PCY is a fund that buys government debt in emerging market countries.  It’s got about $4.5 billion in assets, making it the second largest ETF in this space.  However, the largest fund in the emerging market debt space is far bigger.  In fact, iShares JP Morgan USD Emerging Market Bond ETF (NASDAQ: EMB) has $12.5 billion in assets.

And that’s not all…

Not only is EMB the more popular fund, it’s also much more heavily traded.  Average daily options volume in EMB is about 10,500.  In PCY, the average is 8.  That’s right… 8 options per day.  When over 25,000 options trade in one day in an ETF that normally averages 8, it definitely draws attention.

In this case, it wasn’t actually one huge block trade, but several smaller blocks of the September 27 puts (with the stock around $27.25).  When you have a name like PCY which isn’t liquid in options, you may see the trade broken into many smaller parts to get it filled.  And sure enough, there were lots of pieces traded, from roughly 200-lots up to 1000, with prices ranging from around $0.60 to $0.80… mostly purchases.

This would lead us to believe the trader (or traders) think the ETF is going down by the end of the summer.  That in turn means there’s a fair amount of money (something like $1.5 million) betting that emerging market government bonds are going to take a hit in the coming weeks.  You can see form the chart that PCY has been on a sharp run higher the last week or so.

This leads to several questions….

If it’s a hedge against a downturn in emerging market debt, why not use the much more liquid EMB options?  For that matter, even from a speculation standpoint, you could probably get better fill prices on EMB options.  Their implied volatilities were about the same at the time of the trades, so it doesn’t seem to be a relative value proposition.

I can think of two reasonable explanations, although I’m sure there are others I’m not considering.  First off, the trade could have to do with the actual bond holdings of the particular ETFs. On the surface, it looks like PCY and EMB have similar exposure to countries and credit ratings groups. But, drilling down may show one has more or less exposure to a potential default candidate.

(For the bond nerds out there, EMB does have quite a bit shorter duration than PCY, but that’s probably not much of a difference maker.  Perhaps more importantly, EMB has over 400 bonds in its portfolio while PCY has just over 100.)

The other potential explanation is more nebulous.  Perhaps there’s something about the actual structure of the PCY ETF which is amiss.  It may be that someone very smart has figured out that given the structure of the bond portfolio, the ETF price should be lower than it is.  That’s not the sort of thing I can prove, but we should know by September if PCY drops more than EMB.

No matter the reason, it may not be a bad idea to take a flier on PCY puts, especially if you’re bearish on emerging market debt.  After all, we have all kinds of tariffs to consider which could hurt emerging market countries.  And, the debt problems in Italy could spill over into emerging market bonds as well.  For under $0.75 a put, it’s not a bad gamble to make for those looking at something a bit more speculative to trade.

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What Does This Huge Options Trade Mean For Oil?

When I write about large options block trades, it’s generally for one of two reasons.  First, a lot of smart money is active in the options market.  If a very big (i.e. capital intensive) trade occurs with options, it can often be a signal that there’s going to be action in the underlying asset.

Second, sometimes I just find an options trade very interesting and worth discussing.  It could be because it’s an unusual trade or is an original way to handle risk management.  Of course there are times when I write about a large trade because it’s interesting and may provide meaningful insight into the underlying asset.

A trade last week I came across meets both of those criteria.  More specifically, I noticed a massive covered call trade in United States Oil (NYSE: USO).

USO is the most active oil ETF.  While it has its flaws, trading USO is probably the easiest way for the average trader/investor to trade oil.  Beyond trading oil futures themselves, USO is likely the most direct way to trade oil as well.

Covered calls can be intriguing to analyze because they can be successful in many different types of market conditions.  However, one of the few situations which are “bad” for covered calls are when the underlying asset price blows through the short call strike.  (It’s not entirely bad since you are still making money, but you could have made more money by just being long the asset.)

So, is this covered call trade suggesting there’s a limit on how far oil prices are going to rise?  Let’s take a closer look at the position.

The trade involved a massive 60,000 USO January 2019 calls, which means 6 million shares of USO were purchased against the calls.  The call strike sold was the 15, and the stock was right around $15 at the time, in other words, the calls were sold at the money.

The 60,000 options were executed in two separate blocks.  And, if you average the prices together between the two blocks, you get an average call sale price of $1.35.  That works out to $8 million in premium received (or a 9% yield over a roughly 7 month period).

With the short calls being sold at the money, the trader clearly does not expect USO (and thus oil prices) to continue climbing through next January.  Otherwise, he or she would have sold out-of-the-money options instead to give USO room to climb.  (Clearly, as you can see in the chart, oil has already seen sharp gains in recent weeks.)  With the at-the-money trade, the max gain on the trade is right at $15 at January expiration.

On the other side, the call premium collected means the USO shares are hedged down to $13.65.  Plus, the trader may not expect the shares to be offset by the short calls next January.  Instead, he or she may be happy to be left long the shares for an effective price of $13.65, and could always continue writing calls against those shares moving forward.

If you believe oil’s price increase has run its course, this is a good way to generate income on it, while still giving you a chance in to be long the shares next January.  If you think oil has more room to run, you can always sell a higher call strike.  The 16 strike trades for about $0.75.  That’s not a bad credit to receive, while also giving yourself a bit of upside potential in the stock price.

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How You Could Make 650% On This Copper Trade

The only thing certain when it comes to trading in 2018 is that this year has been far less predictable than previous years. While the last few years were marked by low volatility and a mostly bullish stock market, it’s obvious that 2018 is an entirely different animal.

So far, 2018 has been characterized by significantly more volatility than we’ve seen in recent times. While it wasn’t reasonable to assume low volatility would last forever (and it did feel that way for a time), the extreme moves in market volatility have caught many traders off guard.

The biggest source of market volatility has been the US administration, particularly the administration’s position on tariffs and international trade. In a nutshell, the US is levying new tariffs on international goods, and it’s slowly leading to a trade war. Whatever your opinion on trade wars and tariffs, it’s very clear the stock market doesn’t like the idea (based on substantial downturns in stock prices whenever a new tariffs is mentioned in the news).

Tariffs can be used to tax all sorts of trade goods, but are often levied on commodities and raw materials. The first ones used this year were on steel and aluminum imports, for example. These sorts of tariffs can wreak havoc on the commodities markets as well as stocks that are involved with the affected goods.

On the other hand, the global economy has been quite strong lately, and is showing no signs of abating anytime soon. So how do you weigh the pro and cons of investing in certain commodities? What do you do with an important trade good such as copper? The widely-followed industrial metal tends to perform well when the economy is growing, but also could feel the sting from a trade war.

As always, I like to look at the options markets for clues on traders’ sentiments. Options action can give insight into investing trends in all sorts of assets and products.

One very bullish case for copper came in the form a massive call spread in Freeport-McMoRan (NYSE: FCX). FCX generates revenues from several products, including copper, gold, and oil. However, roughly 60% of the company’s revenues come from copper, and it’s the largest copper company in the world. As such, the stock price tends be very sensitive to the price of copper.

This week, a size trader made a very big bet that FCX (and thus copper) is going to be climbing this summer. The particular trade was the August 17th 17-20 call spread (buying the 17 call, selling the 20 call) for $0.41. The stock was around $15.50 at the time of the trade, and breakeven is $17.41.

The trade was executed 19,500 times, which means the trader is risking $800,000 on the strategy. That’s no small sum, so he or she must be pretty confident that copper has some upside. What’s more, the trade can make $2.59 in profit should FCX go to $20 or above by mid-August. That’s over $5 million in profit or 650% gains!

This is exactly the sort of long options trade that I would recommend. You aren’t risking too much in capital, and the returns are outsized if you get it right. Plus, you are buying a decent amount of time for your thesis to work out. If you think copper has a bullish future (though this summer), you’ll be hard pressed to find a more efficient trade than this one.

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A Quick 185% on an ETF That’s Just Now Bottomed

If you have any interest in economic policy, especially macroeconomic policy and repercussions, now is about as interesting as it gets. I realize most people don’t get a hoot about macroeconomics, but it can be very useful for analyzing trading opportunities. (For me, it goes beyond that since I have a degree in economics which focused heavily on the macro side of things.)

We’re experiencing a real life experiment on how tariffs and trade wars are bad for an interconnected global economy. Tariffs can gain political traction because they are supposed to create or protect domestic jobs. However, as soon as other countries imposed their own tariffs, it generally just comes back to bite the industries that initially were supposed to be insulated.

For a developed nation like the US, a trade war would probably result in something like a 3% decrease in GDP. That’s a big deal when you’re talking about trillions of dollars, but it’s also not catastrophic. On the other hand, tariffs can be extremely detrimental to the growth of emerging market economies.

iShares MSCI Emerging Markets ETF (NYSE: EEM) is an extremely popular ETF for trading a basket of emerging market stocks. The heavily traded EEM does almost 70 million shares per day in share volume plus 400,000 options on average.

As you can see from the chart below, emerging markets have taken a pretty big hit lately. EEM started trending down when tariffs became a major news item. Since the actual implementation of the tariffs, it has dropped even lower.

However, a massive options trade last week in EEM suggests that the ETF is done falling for the rest of the month. This trade, known as a put ratio spread, involved a 100,000 by 200,000 put spread – which is about as big of an options trade as you’ll ever see.

More specifically, a trader purchased the June 29th 42.5 puts 100,000 times (with the stock at $43.50) while simultaneously selling 200,000 of the 42 puts in the same expiration. Now, buying a put spread is normally a bearish strategy, but the trader actually collected a credit of $0.06.

That means if EEM stays where it is or moves up, the position will generate $600,000 in profit. The max gain is at $42 on expiration, where the trade would earn $0.56 or $5.6 million. However, below $42 in EEM is where the risk comes in. Every $1 below $42 would result in roughly $10 million in losses. Clearly, there’s big money betting on EEM staying above that level through the end of June.

I like the idea of this trade, but obviously not the risk involved. In fact, selling a put spread is tough in general because the options are so cheap. I think you may be better off betting on a reversal straight up using a call spread.

For instance, with EEM at just under $44, you could buy about a month of time and get the July 20th 44-46 call spread for about $0.70. Break even is $44.70, you can make $1.30, and max risk is just the $0.70 you pay in premium. That’s a very reasonable amount to pay for a month-long trade that has 185% max gain upside.

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Big Money Is Betting That The Markets Will Remain Calm

The days of sub-10 VIX may be gone for the foreseeable future, but that doesn’t mean traders have stopped betting against higher volatility. In fact, the short volatility trade seems like it may be returning with a vengeance.

Well, let me step back a bit. The short volatility trade may be returning on the professional level. Retail traders still appear to be wary of selling volatility – and with good reason. It was the retail crowd that mostly got hurt on February 5th and the aftermath back when XIV, a popular inverse volatility ETN, imploded.

Access to short volatility isn’t quite as easy as it used to be, and I imagine there are plenty of gun-shy retail investors who got burned back in February. Nevertheless, making money on short volatility can be a great way to increase yield and trading returns. Moreover, the big money may be stepping in now and selling volatility in chunks.

XIV, which was basically the inverse of iPath S&P 500 Short-Term Futures ETN (NYSE: VXX), is now out of the picture. ProShares Short VIX Short-Term Futures ETF (NYSE: SVXY) has been redesigned to provide only 50% short exposure to front month VIX futures. As such, it has fallen on VXX and VIX futures options themselves to carry the lion’s share of the volume of volatility trades.

VXX only has exposure to the first two VIX futures months, while any VIX month with a future can be traded using futures options. For the most part, VXX has maintained strong volume since the February 5th volatility event, trading about 44 million shares a day on average over the last 90 days, while options have traded a brisk 363,000 average per day over the same period.

Now, it’s easy enough to take a short position on volatility by purchasing puts on VXX. Of course, puts make money when VXX goes down, and VXX goes down when volatility retreats. That’s a perfectly reasonable strategy. But keep in mind, buying puts does come with time decay risk. Long options are always decaying as they approach expiration, so you do have a timing variable that comes into play.

On the other hand, selling calls on VXX means time is on your side. Being short calls also benefit from VXX going down (or sitting still). But, being short options means you collect time decay rather than pay it. The risk is if VXX spikes higher, your losses can be staggering.

One way to protect yourself against a spike in VIX but also get the benefits of time decay is by selling a call spread instead of selling naked calls. Selling a call spread (selling a call closer to the stock price, while purchasing a farther out call) lowers your premium collected, but caps your losses.

Take for example, this very large trade that occurred in VXX earlier this week. A trader sold the June 8th 37-43.5 call spread for $0.59 with VXX trading at $34. Selling the call spread means the trader sold the 37 calls and bought the 43.5 calls. The spread was executed over 6,200 times meaning the trader collected over $367,000 in premiums.

If VXX closes under $37 in the next 17 days, the trader keeps the entire premium collected. On the other hand, if VXX spikes above $43.50, the trader is at risk of losing $5.91 ($6.50 spread gap minus the $0.59 premium collected).

It may seem like $0.59 isn’t a lot to collect versus a max loss of $5.91. However, the trade only lasts for 17 days. Moreover, with the China tariff situation seemingly resolved for the time being, there aren’t a lot of potential volatility catalysts on the horizon.

Still, while I like the idea of selling a call spread, I’d probably go a bit higher out of the money and go farther out in time to compensate. For instance, the June 29th 39-44 call spread would result in around $0.70 in premium versus a max loss of $4.30. You have to wait a few more weeks until expiration, but it would take a pretty major event at this point to push VXX to $40 or above. To me, that’s a reasonable trade off to make.

To learn more about trading volatility for quick profits check out my new training video, Simple Steps You Can Take Right Now to Trade Volatility Like a Pro. It’s completely free and no registration required.

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