Competition and automation have made today's options markets much more efficient and fairly priced than they were when I started trading back in the early 90s. Back then, markets were at least 6 cents wide (a 'teeny') and in many cases a full eighth of $1 wide from bid to ask, plus the market-makers enjoyed a bit of a cushion since disseminated quotes were not 'firm' and could be faded if needed to avoid losses. With these generous spreads, dealers could profit without assuming much real risk - simply capturing that sixteenth or eighth of a point on a share of daily volume added up to plenty of revenue (recall my first employer, the Hull Group, was bought by Goldman in the late 90s for half a billion dollars!).
Today we see penny wide markets for most liquid names, and anomalies in terms of price and implied volatility are few and far between. This is one reason many option market makers have left the business and we are down to a handful of large super-market makers who use cutting edge technology to quote all 518,000 individual options on 3,815 listed products at once, using very few humans.
This market evolution has favored the customer, since prices are tight and electronic execution is cheap and fast, and given this landscape, I like to try to find trades that are on the 'right side' of some sort of pricing conditions -- whether we are talking simple level of implied volatility, or put/call skew (smile), or volatility term structure, or even simple underlying stock price or multiple of price to earnings. Whether my "guess" on direction turns out to be correct, I feel like this gives me a bit of an advantage simply because I can avoid selling 'cheap' things or buying 'rich' things.
We all saw the market rally and CBOE Volatility Index (VIX) get crushed after the cliff was (for now at least) dealt with by Washington -- and this idea of staying on the right side of extremes would have worked fine for VIX- which was above 20 last week -- and near the highest levels of 2012 (although we did see 27 briefly last summer).
Today, as the market sits near flat and VIX is back below 15 we can look at a few liquid names that are near the highest level of ATMIV skew (puts over calls), these stocks can provide the richest pay for downside risk, and that can be put on with a collar (buy call, sell put, take in credit) or even a long put spread for a debit.
Gamestop (GME) is one name at an extreme -- stock near $25.64 this morning and the Feb 24-27 collar (or risk reversal) can be entered for a slight credit, about $0.07. Exposure is like owning shares above $27 or below $24, so the downside risk is significant, but not much different than shares. Stock is at the upper end of its 52-week range of $15.73 to $27.83 and my view is more on vol skew than share price. If you hated the stock, the steep put skew also makes the 26-24 put spread relatively cheap at about $0.90 and you are selling the 24s about two points above the 26 strike.
Trades: Buy to open 5 GME Feb 27 calls for $0.72 and sell to open 5 GME Feb 24 puts at $0.80.
Stop loss $0.50 debit. Profit target $1.00
OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits
Select the service that is right for you!COMPARE ALL SERVICES
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
- Real Money + Doug Kass Plus 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas