Valspar (VAL) Options Activity Signal into Takeover Announcement

On March 20th, 2016 Sherwin Williams (SHW) announced an $11.3B deal for Valspar (VAL) at $113/share cash with Valspar having closed at $83.83. VAL was a name consistently highlighted to clients with unusual options activity.

Key Takeaways:

  • Multiple Days of ITM and OTM Call Buying with the Stock Weak and Strong and Steady Growth in Call Open Interest


  • Aggressive Purchases (Buyer Paying Offer or Through the Offer on Wide Bid-Ask Spreads)


  • Suitable Target – Citi Note on 1-5-16 “We have called VAL a takeout candidate for the past few years so we may sound like a broken record. But we still think VAL remains an attractive target for another large coatings company given the ongoing consolidation of the global coatings industry. Admittedly the company isn’t cheap, currently trading at nearly ~11.5x forward EBITDA. We think Sherwin Williams or Berkshire Hathaway (owner of Benjamin Moore) could be possible acquirers in our view, given that both companies have strong contractor customer base, but are not big in big boxes.”


  • Equity also shows relative strength to market, positive price-action, multiple above 20 day avg. volume up days


It started on 12-3-2015 when 1,600 April 2016 $90 calls were bought to open at $2.05 to $2.10 with shares trading $83. A teaching note, VAL shares hit as low as $73 in early January 2016, and 99% of the time one can get into these smart money positions at a much better entry, even though this call buyer will make nearly $3.7M, the value of the position earlier this year was basically worthless.

On 1-8-2016 a trader bought 2,500 April 2016 $90 calls at $1.45 to open, rolling out of January $90 calls that were sold for $0.25. Those two trades account for 4,400 of the current 5,041 contracts in open interest. VAL was a name, however, that saw unusual call buying on nearly a daily basis, a name with fairly wide bid-ask spreads that saw traders consistently paying the offer and even through the offer to grab OTM contracts.

The April $85 calls have around 3,500 contracts in open interest, a trader on 2-1-16 bought 1,000 at $1.50, and on 2-18-16 a trader bought 800 contracts at $2.

The April $80 calls have 5,439 contracts in open interest, starting on 2-5-16 when a trader bought 700 contracts at $3.80 to $4, added 1,400 contracts the next trading day on 2-8 at $3.60 to $3.90, then another 1,000 contracts the next day at $4 to $4.70, and 900 more on 2-10 at $4.60 to $5.20. On 2-12 1,300 more were bought at $3.50 to $3.70, steady accumulation accounting for 5,400 contracts.

A massive trade as recent as last week on 3-17-16 bought 6,000 July $80 calls at $7.75, a $4.65M trade that stands to profit $15.15M.

Hillshire Brands (HSH): A Takeover the Options Market Saw Coming, Again…

Hillshire Brands (HSH) recently announced a planned acquisition of Pinnacle Foods (PF) in early May and shares initially reacted poorly trading down to $34.25, but quickly recovered and the last two weeks have traded in a $35.25/$37 range.

During this time the options market was positioning for HSH shares to trade sharply higher the next few months with a lot of the activity in July and October expirations.  HSH shares are jumping 23% this morning after Pilgrim’s Pride (PPC) announced a $6.4B cash offer for HSH at $45/share.

The reflection of how the options market was positioned once again can be seen in the IV Skew, it is inverted for June and July.

A few of the large trade recently that were seen since HSH announced it’s deal for PF on 5-12, and were a cause to get long the name, whether via the stock or the calls included:

On 5-12 the October $38 calls bought 10000X at $1.19 to Open; July $37 Calls Bought 3,000X at $0.90 to Open; October $35 Calls Bought 4,000X to Open


On 5-13 the July $35 Calls Bought 6,000X to Open at $2.50 and October $38/$34 Bull Risk Reversals Opened 3,000X


On 5-14 July $35 Calls Bought 4,775X at $2.55 to Open


On 5-15 June $37/$40 Call Spreads Bought 6,000X


On 5-16 June $37/$40 Call Spreads Bought 5,500X


On 5-19 July $40/$35 Bull Risk Reversals Opened 2,500X at $0.50 Credit


On 5-22 October $39 Calls Bought 3,000X at $1.30 to Open


On 5-23 the July $38 and October $38 Calls Bought 10,000X Each in a Call Stupid; A 1,500 Contract Spread Bought October $38/$43 Call Spreads and Sold the June $35 Puts


It is rare to see such consistent upside action in a name nearly every day, so the market was clearly reflecting expectations that HSH itself may become a target, and this is exactly what happened, and these trades stand to gain big.  

The most notable OI into today includes the June $37 calls with 16,072X, the July $35 calls with 21,461X, the July $38 calls with 18,410X, and the October $38 calls with 33,006X.

Analyzing Options Activity Post-Deal Announcement to Gauge Market Expectations

I often analyze options activity to be able to predict future takeovers as markets are not efficient and there are often leaks, but it can also be used to effectively gauge the markets view in names we already are certain are on the block, whether this be from a formal deal offer or a Company exploring strategic alternatives.  I look at the volatility skew profile and the large size positioning int he options to predict where the market expects the stock to end up.

A great example today is AstraZeneca (AZN) where Pfizer (PFE) over the weekend raised its offer, but the stock is trading more than 10% lower this morning after AZN rejected this "Final Offer."  I recently presented the view that this deal was likely to fall apart due to what I was seeing in the options market (and a deal also would face regulatory risks.)

On 5-6-14 I put out the following note to clients:

"Options Market Indicates Little Upside in AstraZeneca on M&A, Potential Greater for Downside"

"AstraZeneca (AZN) is trading 12,000 calls on the day, 2.5X daily average and 70% offer side with sizable buys of June $87.50 OTM calls at $0.55 to $0.65, more than 9,400 trading. However, AZN’s May and June IV Skews are not inverted, which one would expect on a Company that Pfizer (PFE) is looking to acquire. Looking back at some of the recent action to better gauge where the market thinks AZN is headed on 4/28, the first day after deal details were disclosed, the May/July $75 put calendar spreads traded 8,000X to open, while another trade sold 1,500 June $80 straddles for $7, and another bought 1,000 June $80/$85 call spreads at $1.10. On 4-30 a spread put on the October $82.5/$90 call ratio spread 2,000X4,000 at $0.75 debit, while May $77.50 puts were sold to open 8,000X that day, many in spreads that bought June and July $75 puts in diagonal spreads. On 5-2 a spread put on 5,000 June $85/$77.5 bear risk reversals at $0.50 debit. All in all the options positioning is more bearish and aligns with what is being seen in the skew. AZN has rejected Pfizer’s latest bid and there are some reports of the bid going hostile. The $101B Co. now trades 19.3X earnings, 3.93X Sales and 4.7X Book, so room for upside appears minimal. The latest bid of $106B is just 5% above current price, and with AZN unwilling to engage in conversations we could see this deal fall apart."


As we can see the first day after the original deal was announced, the largest trade was May/July $75 put calendar spreads, more than 8,000 opened at $2.35, and with May options expiring 3 days ago, the July $75 puts are set to open above $5, a 100% profit.  In this case we also knew that AZN would close above $77.5 on May OpEx due to the put sale, so a $77.5 put calendar also was a very profitable way to play this event.  The spread from 5-2, the June $85/$77.5 bear risk reversals at $0.50 are set to open near $8, a 1,550% gain.

It’s also great how well the Skew showed where the options market perceived the risk, to the downside, and not to the upside, allowing for these types of trades to be structured.

So, in the future, know that if you missed out being involved on the original deal announcement, there are often still great trades that can be made, whether predicting a deal to collapse, a higher offer, or a long period of a lack of movement.

Red Flags Waving, Mr. Market May Need a Summer Breather

Anyone following me the last few years on Twitter knows I have been one of the most bullish people on this market, and consistently bullish, not wavering back and forth, always seeing value in the market on any dip.  I remain very bullish for the market 2-3 years out, and even for the second half of 2014, but with us reaching near my market fair value of 1,900, the risk-reward here is not optimal into the May-July period, and I just wanted to lay out some reasons why I think we could see a 10% correction.  This may be my first bearish post ever, but here it goes:

I’m not going to go too in depth and will likely forget to list a few of the factors, but frankly, it’s Friday and I’m ready for the weekend.

Reasons the market looks ready to pull back May-July:

1) Treasuries have a relentless bid recently, and as I have discussed recently there was major accumulation of 80,000 Treasury (TLT) July $113 calls.  Although this is just one large position, action in the TLT has tended to be right, and can see my call from 2013 to short the TLT in the 120’s before it crashed to below 105.

2) Sector flows showing a flight to safety.  The consumer staple names and large caps are starting to outperform, a risk-off market, and options action dictating the same with most of the sizable call buying occurring in boring large cap names like McDonald’s, Wal-Mart, Pepsi, along with Energy.

3)  Seasonality – The market tends to struggle in the May-July period, and although I do not have the numbers on me, @RyanDetrick is always posting great data, and also aligns with the Presidential cycle.

4) Price-Action in Momentum – I am watching a premiere growth name like Under Armour (UA) post a fantastic quarter and trade down 10%, and it is happening with plenty of other names as well.  VMware (VMW) was crushed on solid numbers and F-5 (FFIV) gave up its earnings gains quickly and closed lower, just a few examples.

5) The anti-Apple trade – The market has been on a strong run with Apple not participating, but now Apple is starting to lead relative strength, and now being a big, old dividend Co. buying back stock, it’s just another example of the style-rotation to large caps from small caps.

6) The Large vs. Small Cap Divergence – The S&P traded right near record highs this week, yet the Russell 2000 (IWM) remains 5% off the highs and still below its 50 day moving average.

7) Ukraine – This crisis will simply not go away, and appears to be escalating with Russia sovereign debt showing a reason for caution

8) Volatility Depressed – We have seen brief rallies in the VIX, but overall have been in an extended period of depressed volatility, and with some uncertainty regarding how the market will react once the Fed tapering ends, and also other Macro factors, it seems the market is under-pricing risk

9) S&P Weekly RSI Divergence Due to Play Out – The channel up pattern I have been highlighting for a long time now remains intact and the 20 week EMA has been very supportive, but there is a notable divergence in RSI in a downtrend (see below).  The downside levels of interest in the S&P are 1,818/1,775/1,750, but if we take out1,800 again the channel will break and can look for a move back to the 38.2% Fibonacci from the start of the November 2012 low at 1,685, this would align with a 10% correction


There are probably 5-10 more factors I could come up with, and may add at a later time, but this is a start.

Into the second half of 2014 I expect growth to really pick-up and earnings have been coming in very strong this quarter.  Stocks will likely close the year with the S&P above 2,000, but for the current 3 month outlook the reward-risk is not that great at this level.

Furthermore, it’s Summer, enjoy the weather, spend time with family/friends, take vacations, go camping, enjoy nature, and take a break.

The market will be here when you get back, and opportunities will be greater.  Work to live, don’t live to work.

InvenSense (INVN): Traders Position for Volatility, Skew Signalling M&A?

 InvenSense (INVN) finished the day with a strong move the last two hours as implied volatility soared, 30 day IV jumped 21.5% on the day to 63.4%, approaching levels generally seen into earnings.  INVN finished the day trading 42,396 calls, 8X daily average, though most of the action broken into smaller trades.  The April calls saw fresh opening action from the $19 deep ITM strike all the way to the $26 OTM strike where 4,929 contracts traded, far OTM and were bid $0.90 by day end.  INVN’s June calls were hot as well with more than 3,500 $28 and $30 calls each opened.  This is very abnormal activity, and comes after recent rumors that Skyworks (SWKS) may be interested in acquiring INVN.  

INVN’s IV Skew is also indicating that something could be stirring here, inverted for March, April, and June, a very bullish signal, though in the case of INVN it does have 36% of its float short, 26.5 days to cover, and head risen 30% since last October, so the demand for OTM calls may be protective for shorts, but the degree of OTM for these strikes makes it look less likely to be a hedge, and more likely to be speculation. 

On the chart INVN shares are also clearing all time highs set back in 2012, and out of this $16/$22 range that targets a move to $28.


The $1.94B maker of motion technology chips for tablets and Smartphone’s trades 27.7X earnings, 7.79X sales, and 6.3X book, but a premium valuation deserved due to it being in a strong growth market, 2013 EPS growth of 59.5%, 2014 EPS growth set at 32.5%, and projecting 20%+ EPS growth forward.  Topeka Capital was out this morning raising its target to $25 from $21.   INVN does make a lot of sense as a M&A target as we have already seen consolidation in Semiconductors this year, and the larger names have a lot of cash and are looking to add growth and enter the markets that INVN is excelling in. 

One way to play the skew for a possible takeover is via the June $23/$30 call spreads for $1.60, offering more than a 3X reward for risk ratio.


Strategist Sees Clovis Oncology (CLVS) Range-Bound, Albeit a Large One

Clovis Oncology (CLVS) traded 4X daily options on the day mainly due to one large  trade, a trader at the ISE sold 1,000 July $105/$60 strangles at $12.20 to open.  This position is looking for CLVS shares to be in the $47.80 to $117.20 range come July expiration.


The $2.5B Biotech is nowhere near profitable, but shares have climbed 282% the past year on a promising pipeline.  On 2-8 Leerink Swann boosted its target on CLVS to $110.  CLVS shares moved higher last week after updating its CO-1686 program for non-small cell lung cancer, increasing the size of expansion cohorts to build a larger clinical data set.  In January a Citi analyst called CLVS the next big Biotech and highlighted a management reckoned for selling to larger companies, so a potential M&A target as well. 


CLVS saw institutional ownership climb 8.5% last quarter, the 53rd largest holding for SAC Capital who is the 5th largest holder of CLVS stock.  The success of CLVS largely depends on CO-1686 in NSCLC but it also has Rucaparib for Ovarian cancer and Lucitanib for breast cancer as other pipeline drugs, and makes it even more attractive as an acquisition candidate. 


CLVS also has a beautiful chart with shares seeing accumulation and heading back near 2013 highs, looking to take out the $85 level to leave a 35 point range, and a flag that measures to a $155 target for shares.  


A trade to consider is buying a 1/2 position in CLVS at $83.50 and selling this strangle for $12.20, resulting in a $71.30 net entry willing to be called away at $105 ( +47.25%), or adding to your stock position at $60 is shares were to violate the $60 level.

Euronet Worldwide (EEFT), A Fallen Star Worth Catching

 A risk-reversal is a professional trade used to maximize leverage and generally shows a lot of confidence in a view, the trader willing to buy the stock in size ( puts sold), but also wanting upside exposure ( calls bought) and uses proceeds to purchase upside calls.  Now, when I see these trades done for a net credit I see them as less confident as the trade can make money as long a the stock trades above the sold put strike on expiration, and just shows a willingness to buy the stock.  However, when these trades are done at a net debit, the trader is not only willing to buy the stock at the strike where the puts were sold, but is outlaying money to take this stance, an expectation shares will not only be above the sold put strike, but also above the purchase calls strike.  

Seeing these trades in stocks that are rarely active with options is even better for me, it turns my attention to a name that a lot of others are not following, but someone that is surely confident and did the research/work in the name, is putting his/her money on the line.

This was seen today in Euronet Worldwide (EEFT), so let’s take a look:

Euronet Worldwide (EEFT) traded 100X daily options as a spread at the AMEX bought 1,000 August $40/$50 call spreads at $2.64 and sold 1,000 August $35 puts to open at $2.05, a large bullish covered risk reversal in a name that barely trades options,

Shares recently dove on earnings and are attempting to hold above the 38.2% Fibonacci at $37, a stock that ran to $50 from $17.50 in nearly a straight line, but also re-testing a 2006 top at this level, so potential to base. 



EEFT reported $0.63 vs. $0.57 and $375.4M vs. $384.9M, fairly solid, so it is surprising to see shares so week.  The $2.03B provider of payment and transaction processing solutions (a hot space for both M&A and IPOs to come), now trades 14.65X earnings, 1.44X sales, and 3.19X book with 13-15% forward growth, attractive on valuation.

Back in November Piper met with management and came away positive, a $56 target on shares noting strong trends with ATM growth, DCC for ATMs and POS, Poland, Google Play/ iTunes, and additional banks following Swiss Post.

EEFT is a top 10 holding at a few firms, Granahan Investments, Van Berkom, Awad Asset Mgmt., Arbor Capital, and Hood River Capital.


It is definitely a name worth a look long, easier with the stock due to wide spreads in the options.


Affymetrix (AFFX) is another name that traded May $10/$7.50 bull risk reversals 3,000X today, very unusual, but of less interest due to its fundamentals and the spreads were done at a net credit.

Time Warner (TWX) Upside Calls Attractive with Further Re-Org. Potential

 Time Warner (TWX) shares have been fairly quiet with many of the top media names like Disney (DIS) and CBS Corp (CBS) rallying sharply to new highs.  It’s a name worth a look at this level looking forward the next 6 months, and will break it down below on each degree of analysis.


Time Warner (TWX) has a $58.63B market cap and trades 14.36X earnings, 1.97X sales, 1.96X book and 28.77X FCF with a 1.77% dividend yield, and 15% forward EPS growth projected.  TWX has a record of consistency posting 5 straight years of double digit EPS growth, and in 2013 FCF rose 20%.  TWX also recently raised its dividend 10% and announced a $5B buyback. 

Now, the value I see in TWX is that when looking at its report it clearly is segmented into 3 companies, Turner Broadcasting (TV), Home Box Office (Premium TV), and Warner Brothers (Movies).  Time Warner has already decided to spin-off it’s publishing segment, Time Inc., and I think it could easily decide to spin-off one of its segments, most likely Warner Brothers to focus more on TV (recent new investment into a sports network), and after recent Box Office success (Lego Movie, The Hobbit, Gravity). 

Analysts target include FBR Capital at $85, Bernstein at $73, and Wells Fargo at $75.

Institutional Ownership:

TWX is a #9 holding at Dodge & Cox, #6 holding at Viking Global, and #9 holding at Longview Partners, notable gurus.


TWX recently put in a strong reversal hammer bottom on a re-test of its former 2013 top breakout, and also held near support that was created in August 2013, still in a strong uptrend.  TWX shares are currently consolidating below its 20 week EMA, and a move above $65.50 sets up for a measured move out of this small cup and handle forming to $70 for the chance to make a run through its highs.


Options Activity:

TWX has seen some notable upside positioning in calls that remain in OI:

·         5,000 July $72.50 calls bought to open $0.78 to $0.80 on 2-6

·         March $67.50 Calls Bought to Open 15,000X on 1-27 at $0.52

·         7,000 April $70 calls in OI from a series of buys


TWX options are fairly cheap with IV30 at 19.2%, the 29th percentile for the past year.  The July $67.5/$75 call spread at $1.50 is a nice reward/risk strategy.

Categorizing the Types of Options Flow Analysis and the Research Process

 This is a follow up to "Methods to My Madness – Trading Options Flow" from 8-29-2012 where I explained my style of trading. (Link to 8-29 Article) (Sorry the format on the blog got messed up).

The strategy of trading options flow has become a lot more popular since I posted that article, but now to a point where there is a lot of sloppy work, and most of it is focused on the what instead of the why. This has caused a push for quantity over quality, hundreds of "unusual" trades posted daily across Twitter, and then you only hear about the 20% that end up working out, and hear about them over and over again, while the 80% fails are never discussed (the ole’ throw a bunch of crap against the wall and hope something sticks approach). The only way to improve on the success rate is to focus more on the why than the what, an ability to be selective by utilizing a strategic research approach to each case to analyze the trades from every angle.

I could, and hopefully someday will, write a book on this art of trading, but I do not want to give away all my secrets, though hope I can shed some light to put people on the right path as the popularity of this style rises.

The first step in the process in clearly the "discovery" phase, finding unusual and/or large options trades that provide a signal. There is value in each, both unusual trades and also in large trades. I will discuss each briefly.

Discovery of Unusual Options Trades

To simplify what qualifies as unusual I would look for at least 1,500 contracts to trade in a stock that on average trades less than 1,000 contracts a day, either on the call or put side, but generally more interest in the call activity due to the natural market long bias where puts are more often hedges on long stock positions than calls are on short stock positions.

In searching for unusual trades there is generally an event catalyst that is the rationale behind the trade, or in certain circumstances information is known by one individual or a select few individuals that can move the stock. These traders are not taking 1,000 lot positions because for one they typically do not have the account power to make that kind of sized trade, and second to stay under the radar in case of a SEC investigation.

I’ve utilized this method to be long dozens of names that were bought out within weeks of the unusual trades, a recent one last week was Accelerys (ACCL). I focus on names seeing action 1-3 months forward and usually under 2,500 contracts, often accumulated over 3 or more days, and aggressive (sloppy / not professional) orders paying offers on wide bid-ask spreads.

These type of trades are often in small caps where information dissemination is not as instant, and also there is more value to be found in names that are not covered by every sell-side Analyst on Wall Street, and traded by every day-trader on the internet. A lot of Biotech stocks often pop up on these scans and that is for a couple of reasons, first there are always events taking place in these names, second it is a naturally speculative trading sector for M&A and the big score type moves, and third there are a lot of smart people that specifically focus on this industry, do the proper research, and are willing to put money behind his/her view on where the stock is headed.

There is definitely value in this style of following options flow, but it is also a style that comes with a much lower hit rate, and takes years of experience to be able to spot the ones worth pursuing.

The type of trade is also notable, one thing I have discussed many times is seeing large opening put sales in < $10 Biotechs, and this I have seen 85%+ success rates buying these stocks when the trades hit, and often for 50%+ moves in the stocks within weeks. Risk-Reversals are always a confident trade, and these are made by professionals, selling puts to finance call purchases, and in 2014 seeing a lot of cross-month risk-reversals in smaller names, and these have paid off big in January, a few recently were ZLTQ, BABY, FLDM, and ARAY.

Further analysis is always required, looking at trends in the volatility, skew, and watching for multiple days of activity.

Discovery of Large (Institutional) Options Trades

I qualify a 500 contract lot as large, but typically want to focus in on at least 2,500 block contracts, and also take into account the contract price, so the net premium and net delta of the trade, the larger the better. These are the type of trades that the smart money are making, hedge funds and other big-time traders. I have covered this topic before, so I do not need to go in depth describing the reason to follow these trades.

These trades are often said to be "cheaters" by the critics when they work, though in reality man of these trades that work are a self-fulfilling fruition, meaning that activists position in stocks via large option trades, and then make news when they push for board seats, spin-offs, asset sales, etc. that causes the stock to jump, and thus the option positions to gain. The traders did not know something would happen, they actually are making the moves happen.

The best trades to follow are the event-driven trades, that is where the money is made for the real big moves. Smart Money is not looking at charts for breakouts, bottoms, tops, etc., these are fundamental based trades that see value in a stock that others may not yet see, and position to be able to push for this value to be realized.

Phase 2: Researching the Why

After discovering the unusual/large trades as a signal, the most important stage is getting inside the mind of this trader to determine why he/she is positioning, in what direction, and for what time-frame, and you can draw conclusions to either emulate the given trade, or pursue your own strategy. I will not cover everything in this piece, but will give a good view of my process.

The first analysis is fundamental, the most important reason for a stock’s movement over time. I look at the main metrics like P/E, P/S, P/B, P/FCF and EV/EBITDA while taking into account what phase of growth the company is in to determine the appropriate valuation technique, also realizing that traditional metrics often do not apply, and industry-specific and even company-specific metrics are often more important. I also look at 5 year historical ranges and averages for the metrics noted above, while for momentum/growth stocks look at not only its last 6 quarters of earnings vs. estimates, but also the stocks reaction to the numbers to gauge sentiment. A deeper dive into fundamentals can often reveal the catalyst that can move the stock, a very important factor. You also want to be paying attention to relative strength in sectors, and investing themes that are hot and can be applied to names popping up on scans.

The second phase of the analysis is technical. Although technical analysis is not a useful tool in determining what stock to buy/sell, it is very useful in determining WHERE to buy/sell. I keep things rather simply, using a lot of trend lines and flag/triangle patterns with measured moves. I also use moving averages and Fibonacci retracements, but do not bother with all these other crazy techniques with Waves, Sharks, ABCD, and whatever else, less is more. RSI, MACD, and On Balance Volume are my main secondary indicators, mostly useful for divergences and/or oversold/overbought indications. Once determining key levels for a stock you can look to set alerts, and position in the names when you want, not always right away once the unusual trade is spotted, it often pays to be patient. I will say that these large and unusual trades are often right and make large profits, but the timing on entry/exit of these large trades if rarely ideal, perfection is not attainable in trading.

The third phase I look at is Analyst upgrades, downgrades, commentary, and price target changes. Although this should not determine a buy/sell, it can be useful in gauging where Analysts have targets for stocks, and the commentary often has a lot of value in potential catalysts for the stocks, or at least important material information that will impact the stock in the near future. I’m lucky to have access to all the best research on the Street, and this goes a long way.

The fourth factor I look at is trends in short interest. If unusual/large call buying alerts me to research a stock, but then I see over the last 3 months short interest has double, I am wary to follow the action as being bullish, a case where call buying can be hedging for event-risk. A 5,000 contract purchase of a 50 delta contract is equivalent to just 250,000 shares of stock, so if short interest in 3 months has risen by multi-million shares, it gives that call purchase a lot less meaning.

The last factor, and one I have just started to incorporate more for subscribers this year is diving deep into ownership trends. I look at Institutional ownership changes for the most recent quarter of filings, and also look at the largest holders of the stock, and the ranking for that fund’s holdings in terms of size. This allows me to often spot a notable guru that is involved in the name, or even better a known activist (I have a list of 35-50 for subscribers). This is just another factor that can increase/decrease my interest in a stock, and all about increasing the confidence in being able to determine just what the goal is for this option trade.

I realize this may seem to be an arduous process, but the truth is that it is very necessary if you want to have a high hit rate. There are no short-cuts, do the work, develop your own process, and take the trades that align on all scales of analysis.

Discovering and Analyzing options flow is very lucrative, and a must-have tool for any serious trader to supplement his/her main style of trading. It also is great for idea generation, as it often starts me on my research path to discover companies I know little about that turn out to be major success stories, a fun aspect of this method, and also rewarding, both monetarily and as confirmation of a well thought out process being turned into substance.

Thanks for reading, and hopefully this will help you better sort through information overload on Twitter.


Trading Inverted Implied Volatility Skew with Vertical Call Spreads

A discussion today on Twitter led me to thinking this could be a helpful topic to discuss…

It is Friday, so will keep this short, and hopefully sweet.

I often will note "inverted" or "bullish" skew when discussing a stock’s options IV (Implied Volatility) profile. I do not want to get into a deep explanation of the concept as it is readily available with a simple Google search. It is one of the more important concepts in options trading, and suggest diving into the topic deeper.

Basically a normal IV Skew reflects higher IV in the OTM puts compared to the ITM Calls/Puts and OTM Calls, sloping down from left to right as strike prices increase. The reason for this is that the need for protection via puts drives up demand of OTM puts with the natural market long bias in stocks, and there are some other explanations as well, but that is the simple conceptual view and without being too mathematical and the takeaways are more important.

There are occasions, fairly rare, where the IV Skew inverts, also called a bullish IV skew and often referred to as an IV "smile". What this is showing is an upside bias as the demand for OTM calls is so strong that the IV profile "flips" and the demand for OTM puts is weak, so longs see limited need for protection, a view of limited downside with a strong bias towards an upside stock move.

A recent case of this for August was in Anadarko Petroleum (APC) where the IV Skew inverted with strong demand for the OTM calls, seen ahead of its 7-30 earnings date, though the Institutional sized traders in the calls looked to be expecting an additional catalyst such as the litigation with Tronox (TROX) or drilling results. You can see the August OI as of today in the $92.50 calls was 22,991 and 42,130 in the $95 calls, each of which expired worthless, which brings me to the important takeaway.

Conceptually the activity is implying a view shares will close that expiration above the given strikes being bought, and this IV driven higher in the contracts. However, my takeaway with this is that if the expectations are for that kind of move the higher probability trade is utilizing vertical call spreads that will not offer the same kind of returns as striking gold in the OTM calls, but is a more intelligent way to trade.

In this case the trade was to be buying the "cheap" (in relative IV terms) $87.50 calls, and sell the "rich" (again, in IV terms) $92.50 calls. The APC August $87.50/$92.50 call spread was available for less than $2 into earnings and closed today just above $4, a 100% gain, and clearly the better trade than being long the OTM calls that expired worthless, or even the stock itself.

This is my preferred method, while another strategy would be to put on calendar call spreads, selling the front-month OTM calls that are "bid-up" (meaning bullish IV skew profile), and buying the next month ITM or OTM calls that are cheaper in IV terms, a calendar or diagonal spread. The issue with this strategy arises if the positive catalyst comes in the front-month before expiration and blows through the upper boundary of the profit zone.

We recently applied the vertical call spread strategy in Family Dollar (FDO) that was exhibiting a bullish IV Skew, well ahead of the recent takeover chatter, and put on August $70/$75 call spreads for $0.60, and were pricing above $3 on the recent spike, a quintuple.

Now, if you made it this far I hope you enjoyed the article, and as a reward a case of IV Skew inverted for September that looks unusual is in Qlik Tech (QLIK), where a strategy such as the September $33/$37 call spread at $1 debit makes a lot of sense for a 3:1 reward/risk, and a name that has been trading very well and can be a candidate for M&A.