Nice eyes, Professor Succo!
A few months ago, I alluded to a trade we did in United Parcel Service (UPS). Let me describe it in a little more detail as I want to use it as example of how markets work.
We know this stock well. There is/was nothing particularly wrong with the company; that's what created a problem with the stock.
People pay up for no problems. The trouble is they lose sight of what they are paying. UPS stock price chugged along nicely for some time. People became further enamored. No one sold. The company employees own a lot of stock and don't sell much for some reason (maybe that is frowned upon inside corporate halls). A pretty good company's stock price at 26 times earnings began to look rather peeked to me.
Combine that with very cheap options (ridiculously cheap in fact) and I got very interested. I waited for a large seller of options to build a position.
And then one found me. My favorite type of seller of options are over-writers. Sometimes they sell rich options and I don't care. More often than not though that is just a function of the market itself for they are in the business of selling options and most times they are fairly indiscriminate (there are always exceptions and I know a few very smart sellers of options; these sellers mostly look for very rich puts in value situations however).
In this case an over-writer began selling 80 strike calls at $.20 when the stock was at $72. I imagine there was not much analysis (for if there was it was pretty shoddy), probably the seller just figured the stock would not get to $80 and this was "free money". These options were so cheap in volatility terms that I loaded up on them and hedged them lightly (I did so for technical reasons when trading cheap options, not because I liked the stock).
The stock grinded higher and higher. Those out of the money options went in the money to the tune of $8.30 (stock price of $88.30). I have no doubt that the seller of those options at $.20 contributed to that rise as they probably realized their mistake, panicked, and re-hedged the position, which creates stock to buy. I obviously was completely hedged with short stock at this point. I just waited, not knowing anything, but having the probabilities with me.
And then it happened. The company missed earnings by just a little and guided down for 2005. For a fairly valued stock this may not have been such a big event. But in this case all those people who had been paying higher and higher prices for the stock suddenly came back to reality. The subsequent behavior of the stock was typical: a mini crash, a small recovery, and then more selling.
Those options went from $.20 to $8.30 to zero and then expired worthless. For a volatility trader, that is a home run. But I didn't really have to work for it. I just swung the bat through the strike zone and the probabilities worked out. I entered the trade for no other reason than knowing that when people over-pay for something bad things can happen.
And that is how markets work and why volatility exists at all. People make mistakes, one of which is just over-paying. Another is "not understanding risk". The Fed helps them to not understand risk.
I am now building a position in Boeing (BA) for the same reasons: cheap options and an over-valued stock at nearly 28 times forward earnings. A large retail broker recommended the stock this morning. Perfect. I will just scale into the strength setting up a typical long volatility trade (long calls and short stock).
I will just swing down the middle of the plate and see if the probabilities work. I won't swing for the fences, I am just looking for a hit.
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