MONEY AND FINANCE

by Alan Friedman
Editor / The WOLF

READ THE UNCUT, UN-EDITED VERSION OF THE ARTICLE WRITTEN BY THE WOLF, PUBLISHED IN THE 12/21/98 ISSUE OF BARRON'S "THE STRIKING PRICE" COLUMN

For many investors, the options market is a confusing jumble of striking prices, expiration months, straddles and strategies. There are so many different stocks one can trade, and so many different options to buy. Many option traders would love to simply buy the same options that the so-called "smart money" is buying. Of course, trying to find accumulation in the options market is easier said than done. However, I have developed a unique methodology using option volume and open interest that can help you find those options that are possibly being accumulated by "smart money".

What is "open interest"? Simply put, open interest is a number that represents the amount of contracts created for each option. When a buyer and a seller get together on an options transaction, and both are initiating new positions, open interest is created. If Trader "A" thinks that a call option is going to rise, he places an order to buy the calls. If the seller, Trader "B", believes the options are going to drop in price, and he does not already own the calls, he is creating open interest buy selling the calls to "A". If the calls then rise, and "A" sells to "C", no open interest is created because "A" is closing out his position when he sells the calls. If that is too complex to remember, don’t worry! The main thing you need to know is that options with high open interest are usually very active and options with low open interest are usually inactive. It’s the latter that I watch carefully.

Options with low open interest are, by definition, ignored. The strike price might have been just added, the particular month might not be active, or the underlying stock might be "dead" money. Due to the lack of activity, options with low open interest often times have wide spreads and are not liquid, two characteristics that scare the retail options buyer away. Therefore, when high volume comes into an options with low open interest, it oftentimes could be the result of what I call "smart money accumulation" of the option.

What would be the reason behind this accumulation? It could be one of many things. Many of these trades start to move after a news event. For example, on 11/6/98, the DONALDSON LUFKIN JENRETTE (DLJ) December 40 calls traded 3809 contracts with open interest of 273. This high ratio of volume to open interest, along with some other technical tools I use, indicated a strong possibility that these calls were purchased by "informed" buyers. My subscribers bought the calls on 11/9 at 2 ¼ and our target was 4 ½. The first week of the trade did not go well for us as DLJ slipped from 37 7/8 to 33 and the calls droped to a buck. But the next week sw DLJ spring back to 39. And on 11/23, DLJ finally ran up to nearly 44 after news of the BANKERS TRUST merger. The calls easily hit our target. Did someone know about the BT deal in advance, and decide to play DLJ? After all, DLJ had long been rumored as a takeover stock and would expected to rise in the wake of a mega-merger involving BT.

This past summer saw an interesting signal from HOME DEPOT (HD). On 5/14/98, the HOME DEPOT June 75 calls traded 5697 contracts with open interest of 1933. Again, this ratio of volue to open interest was consistent with "smart money" accumulation of the calls. The technical rules we use confirmed this and the calls were bought the next day at 1 5/8. Within days, HD announced a stock split and a dividend hike. The calls were sold at 5. Did someone know about the dividend increase and the split in advance, and buy the calls?

Not every trade involves a news item. On 10/9/98, the SYNOVUS FINANCIAL (SNV) November 22 ½ calls traded 3000 contracts with open interest of 254. We bought the calls at 15/16 on 10/13 and sold 10/16 at 2 3/16. No news came out that ever accounted for the rise in the stock.

I must give you a warning. Simply using option volume & open interest in this manner will most likely end up wiping you out. I trade only about 2 times a month because my technical filters eliminate many signals. I use moving averages, standard technical chart patterns, and some common sense rules. For example, if an option is active and you ee that the company was rumored to be a takeover target, eliminate that signal. Usually that is public buying and we want to avoid the public and concentrate on "smart money". Also, eliminate options trading under one dollar. Sure, 5,000 contracts traded at ¼ seems impressive, but it is not the same dollar commitment as 5,000 contracts at three dollars! The former might be a gambler taking a pot shot, while the latter is a large dollar amount that most likely is not put up for a crap shoot.

Finally, money management is important. Because options trading entails risk, use only risk capital for this type of trading. Take the dollar figure you have earmarked for trading this method and divide it into 4 equal units and invest 1 unit in each trade. You would be surprised at how many seemingly sophisticared option traders shoot themselves in the foot by failing to follow one simple rule: KEEP YOUR DOLLAR COMMITMENT THE SAME FOR EACH TRADE. Too many times I have seen option traders buy the same number of calls for each trade. This is suicide because if the 10 calls you bought at 8 drop down to 5, it will not make up for the 10 calls you bought at 1 that triple to 3. Let me show this to you because it is important and is the one rule that can actually turn you from an options loser to a winner.

JOE LOSER-buys 10 calls of each trade

10 ABC Jan 50 calls at 8, sells at 5-loss 38%
10 XYZ Jan 20 calls at 1, sells at 3-profit 200%
TOTAL LOSS -100%

BRAD WINNER-buys $800 of each trade

1 ABC Jan 50 call at 8, sells at 5-loss 38%
8 XYZ Jan 20 calls at 1, sells at 3-profit 200%
TOTAL PROFIT +2100%

Look at these two traders above. They both had the same options and the same results. Yet, Joe Loser lost $100 and Brad Winner took home a profit of $2100. What was the difference? Joe Loser bought 10 calls of each trade, so he had more money riding on the higher priced call. And even though his losing trade lost only 38% as opposed to the 200% profit of his other trade, Joe had more of his money in that particular option. Brad Winner did the right thing and invested $800 in each trade. By doing this, Brad was able to capitalize on the option that tripled and took a small loss on his losing position. If you just remember one thing from reading this article, it should be that to be a consistent winner in the options market, keep your dollar commitment the same for each trade!

All of these rules add up to a unique options system that my subscribers and I have used successfully. By watching for unusual activity in the options marketplace, you can find what the "smart money" is buying and follow them to options profits.

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