What makes a successful trade?
There are three key factors every trade setup should consider, and when all three are pointing the same direction, one has a high probability option trade.
- Fundamental Analysis
- Technical Indicators
- Unusual Option Activity
What makes a stock deserve higher valuation than its peer group? What makes a stock in the same sector trade on extreme multiples, whether based on P/E, P/S or FCF, while the rest of the group struggles to catch even the broad market multiple? Why is it that dozens of websites, such as Yahoo! Finance, provide common valuation metrics for the average trader, yet the underlying stocks and sectors rarely follow those metrics? We don’t believe in the efficient market hypothesis taught in college textbooks. In reality, markets are anything but rational.
Our fundamental approach to evaluating stocks starts with understanding behavioral finance. What ticks an asset class higher or lower has little to do with its valuation and everything to do with the collective irrational behavior of market participants. We believe emotions and other extraneous factors influence investors every day, and that ticks the market, not P/E ratios. Why do millions of people buy lottery tickets each day, knowing their chance of winning is next to nothing? It’s irrational behavior and it prevails in the stock market every day.
We have access to most, if not all, top notch Wall Street research. We compile this research and hunt for spots where a certain potential catalyst that has a reasonable chance of playing out may not be priced into the current stock price. It starts with understanding how collectively the market participants are positioned, analysts and investors alike, then understanding what could cause those opinions to change drastically. What would be the catalyst, how likely it is to occur, and what would be the timing of such an event?
We don’t care whether something looks cheap or expensive. For all we know, cheap tends to get cheaper and just because something is rich on valuation doesn’t make it an automatic case to go short. We are looking for holes and opportunities in the story. We hunt for inflection points that cause participants’ behavior to change direction. This requires an incredible amount of attention to research and the ability to absorb information rapidly and present those turning points in the fundamental story in easy to understand terms to our clients. That’s the crux of our fundamental research.
We believe a chart only gives us the footwork of previous market participants. It tells us where they have been, not where they are going next. But in a world full of fast-paced algorithms, there are times when trend following is all one needs to extract beta. We use momentum indicators (RSI, MACD) in combination with Volume-Over-Price bars to identify “pressure points” on the chart, a level that would propel significant amount of interest and change in participant behavior if taken out. We use Bollinger Bands in quiet markets, such as in-between earnings seasons, to look for stocks with a potential volatility squeeze for breakouts and breakdowns. At times of low volatility up-trending markets, we rely heavily on bull flags to extract alpha.
Unusual Option Activity
There is absolutely no doubt there are traders much smarter than we out there with much better information. We believe there is no better way for them to conceal activity and make a profit than by simply making a bet in the option market. Hence we pay very close attention to order flows. However, unlike many other options traders, we don’t follow any activity blindly. We separate out buyers and sellers and closely follow how open interest is building over time, especially ahead of a particular catalyst. What makes an activity unusual comes in many forms.
- For short term catalysts such as earnings, we look for bullish implied volatility skew and OI changes since the previous earnings report.
- For large trend reversals, we monitor leap calls and puts.
- Most traders look for volume of contracts to call something out as unusual, but we believe that’s only part of the story.
Large institutional size bets often occur in low volume, high Delta, and in expensive contracts that build over time. Knowing how dollar premiums are moving in and out is just as important as understanding low Delta contracts bought or sold.
There are also activities sparked by simple trend following, and there is nothing wrong with that as long as the trend remains intact. Most aggressive bets happen on wide bid/ask spreads in out-of-money calls or puts that move implied volatility sharply higher. There are times when activity comes through minutes before the closing bell on the offer; these are buyers well worth paying attention to.
We actively use many different ways to construct an option trade and much depends on the stock, event in play, time horizon to catalyst, implied volatility and risk/reward balance.
- Low volatility up-trending markets are usually best served with straight long calls.
- Rising volatility up-trending markets make a better case for vertical call spreads or bull put spreads as income producing trades.
- Neutral state markets with expectations of IV slipping back to near HV are best served with calendar and butterfly spreads.
- Panic markets require being more defensive or aggressive depending on the sectors leading to the downturn.
- Calm before the storm, such as in-between earnings seasons, can be played with long volatility structures such as straddles and strangles, based on technicals and expected fundamental news flow.
Depending on circumstance, we deploy any structure that maximizes the potential gain while limiting losses.
Bad things happen to the best of us. There will be times when despite rigorous checks on fundamentals, catalysts in play, technicals, unusual option activity and proper trade structure, the trade will go bad with little chance of making a comeback. When a trade is not working, it is best to simply let it go. There are better places to park money than to continue to fret over a loss.