Here’s a guest post from friend of the site (and Dan’s Options Action co-panelist) Michael Khouw. We talk a lot about implied moves here on the site and there’s some quick back of the napkin ways you can calculate that. But Mike is very focused on the fact that the options implied move doesn’t incorporate the asymmetrical risk that usual exists. We discussed this a bit on a webinar that Mike, Dan and myself did on The Ticker District. If you haven’t watched that you can do that here.
This guest post delves into some specific examples. It was originally published on TheStreet.com but Mike has been kind enough to let us post it here as well:
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SBUX, What Are You Implying?
A question I get a lot from institutional investors is what are the options markets implying? This is a different question than what are options traders betting on. Here’s the difference.
Yesterday someone bought 10,000 Valero June 60/50 put spreads paying 2.64. This is a bearish bet that $VLO will fall below the June 60 puts they bought by at least the 2.64 in premium that they spent, or below 57.36 by June expiration. That would represent a decline of 6% or more in 65 days. This is a single bearish bet, by one market participant in the same way that someone shorting 1 million shares would be a bearish bet (each options contract represents 100 shares so 10,000 contracts x 100 = 1,000,000 shares).
What that options market is implying overall may be very different than what one trader or investor is betting on. We assume that large trades are placed by smarter and better informed market participants, and many are, but we don’t need to look very hard to find examples of big traders making big mistakes. Long Term Capital Management was an all-star cast with two Nobel Laureates on staff, and they blew up spectacularly. Howie Hubler managed to lose 9 billion of Morgan Stanley’s money requiring a bailout from Mitsubishi UFJ, something none of the rest of us would have gotten if we’d followed his ill-conceived trades.
Efficient market theory states that current share prices reflect all the relevant information that all the market participants know about a stock, and is cited as the reason it is so hard to perform better than the market. Ask people how many jelly beans are in a jar and you’ll get a wide spread of answers. Most folks will be wrong by quite a lot. However the average guess of a large group will come remarkably close to the actual number. This phenomena is known as the wisdom of crowds.
To understand what the crowds are betting on we cannot examine a single trade. We need to examine price, which is the net of all the participants views and actions. This will still weight the viewpoint of larger traders more heavily because their large bets will move prices more than individual retail investors small bets. Imagine a bowling ball sitting in a flat surface is the price of a security surrounded by various actors represented by balls of different sizes and weights. Ping pong balls might be retail investors, of which there could be millions. Billiard balls might represent conventional institutional investors, of which there could be thousands. There may even be a few other bowling balls moving around, these could be the whales that could do a buyout or merger. The price (our bowling ball) will move when it is struck by all the actors. Some will move it imperceptibly, but could move it if all acted in the same way, the retail ping pong balls. The institutional billiard balls will have a greater effect, and the other bowling balls could send ours careening.
Of course when we look at the options markets we have a lot of prices to examine. Calls, puts of various strikes and expirations. Individually these prices don’t tell us how the stock will behave, but collectively they will tell us how the options markets believe the future price of the underlying stock will be distributed. That can be very helpful information indeed.
Yesterday we saw some conflicting signals in Starbucks. Deutsche bank downgraded it to a hold ahead of earnings, yet we also saw some bullish options trades heading into earnings. Why the apparent contradiction? Surely the analyst at DB is smart, but presumably someone who can risk $300,000+ in premium on a short-term bullish bet wouldn’t do so on a whim. Are two of our institutional billiard balls on a collision course?
This histogram shows the implied distribution of Starbucks for April 22nd. The probability that the stock will finish next week between 61 and 61.5 is quite high at ~11% versus the chance that it finishes between 54.5 and 54, which is lower than 1%. What you’ll notice is that the downside tail/range is much longer than the upside one (the stock is presently at $61), probably a function of the fact that SBUX valuation is above average.
By the way the distribution is implying a 35% chance that SBUX is above $62 a week from Friday, and a 38% chance it is below $60.
In this context we see that both institutional players may be making a smart call. From the Deutsche Bank perspective, the above average valuation may be indicating a greater possibility that the stock drops rather than rises AND a larger potential move. If you’re a bull looking at that you quickly realize you should probably use call options to make your bet given that downside risk.