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At the end of March, I reviewed unusually high trading volume in the April 20 calls in the XLI (SPDRs Select Sector Industrial ETF) and decided to sit back and observe rather than participate. The buyer of the calls had apparently cashed out on a big bet perfectly timed at March's bottom and put some of the profit to work on a new bet. This trader earned the privilege of playing with the house's money to grow even more profits - the much coveted "riskless trade." I was reluctant to participate because it seemed unlikely that this trade would offer enough profit to be worth the risk. The chart below shows that these calls had a wild ride on their way to a 4x return on expiration day - a big win by the length of a nose...
We can debate about the amount of risk held in these calls at the time of the trade, but it is clear that a trader could only capture that 4x gain by maintaining a stomach of steel and a lot of confidence with an "all-or-bust" attitude. First, buying the calls based on the volume alone would introduce the first high risk. Many traders would wait a day to confirm the high volume of trading translated into a material increase in open interest. (In Feb, Jud Pyle on stockhouse.com provided an example of high options volume that results in little increase in open interest and provides no expectation for a large stock move: the ex-dividend options trade.) XLI popped 5% the next day putting the likely entry into the April 20 calls around 60 cents as the big move would generate excited expectation for even higher prices. That trade would reduce the final return to a double. Second, XLI promptly fell back 5% in two days rendering the calls nearly worthless at 20 cents. They remained at that price for 3 days before popping and cycling back to 20 cents a week later. Many traders would have stopped out at either point (I have to admit I was tempted several times to try the "all-or-bust trade at those prices!). Note however that the chart above shows that the open interest remained steady until a small and fortuitous dip on April 6th and increased again in the final week. The big trader stuck by the trade - certainly emboldened and enabled by riding on the house's money.
So far, there have been no similarly large trade in XLI options to follow this stellar performance. As part of my on-going effort to track high options volumes more closely, I noted that last Monday 10,050 May 22 calls traded against open interest of 432. Open interest is now 10,563. On Friday, 2,660 May 21 calls traded against open interest of 2,336. The put/call ratio on XLI remains near 52-week lows at 0.31. Confidence remains high that higher prices are right around the corner. With the S&P 500 now trading right under resistance at 875-900, this trade seems to represent worse risk/reward potential than before. Of course, my bearish bias colors my view...
Be careful out there!
Full disclosure: long SDS and long SSO calls. For other disclaimers click here.