Biggest Winners Point to a Trading Opportunity
Market action has been unusual in the past few weeks. One reason has been an unusual rise in options premiums. Generally, premiums do rise when volatility increases but this time there was another factor. Uncertainty about interest rates boosted options even more than expected.
The uncertainty was driven by the new Chairman of the Federal Reserve, Jerome Powell. CNBC summarized the different tone of the new Chairman compared to his predecessors:
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“A few points stood out from his first official meeting as head of the central bank: He is likely to focus more on data than theory; he’s not going to be a slave to projections; and he’s less, well, verbose than the market’s come to expect, at least in recent history.”
The changes left traders concerned about the future path of interest rates. Since the Greenspan era of the 1990s, changes in interest rates have usually been clearly telegraphed. Powell rocked with comments that traders viewed as less clear cut than usual.
The volatility may have been short lived not because traders believe they understand Powell’s thinking any better. The volatility may have been short lived because traders simply priced a worst case scenario into the market.
Now, the market is positioned for multiple rate hikes this year and a less data driven Fed. But, that leaves rooms for upside surprises. This could be the set up for a bull market with little risk. That means trading activity is likely to increase and that means stocks in the business of trading could fare well.
Profits from a Trading Firm
Years ago, trades were executed by market makers. These were individuals representing firms that basically took the other side of the trades. So, if you wanted to sell, someone else would need to buy. The buyer would often be a market maker.
For executing trades, in effect providing liquidity, the market makers earned the difference between the bid and ask prices. Years ago, this was an eighth of a dollar or a quarter of a dollar, $0.125 to $0.25 per share.
Regulations and technology eliminated market makers and they were replaced by high frequency trading firms. These firms now take the other side of trades using complex algorithms and they do so for less than the cost of market makers.
Among the firms engaged in this activity is Virtu Financial, Inc. (Nasdaq: VIRT), a firm famously changing for consistent trading profits.
In regulatory filings required to complete the initial public offering, the company showed a chart of their profitability.
Source: SEC S-1 filing
As the company noted, the chart “illustrates our daily Adjusted Net Trading Income from January 1, 2009 through December 31, 2013. As a result of our real-time risk management strategy and technology, we had only one losing trading day during the period depicted, a total of 1,238 trading days.”
Bloomberg reported on that day the firm lost money: “The aberration happened when it missed a special dividend payment for a stock, throwing off its model and causing a seven-figure loss.”
The company still manages its business the same way, looking for small gains of maybe $1 or less on thousands of trades a day.
Recently, the stock has been rallying and creating a potential trading opportunity.
The stock has been nearly immune to the recent market sell off.
Trading the Trend
When a stock is expected to move higher, traders could consider obtaining long exposure to the stock to profit. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread that could be used. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which is in an up trend.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
A Specific Trade for VIRT
For VIRT, a bull put spread could be opened with the April 20 put options. This trade can be opened by selling the April 20 $25 put option for about $0.35 and buying the April 20 $20 put for about $0.10.
This trade in VIRT would result in a credit of $0.25, or $25 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $5 ($25 – $20). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $475 ($500 – $25).
The potential gain is about 5% of the amount of capital risked. This trade will be for about three weeks and the annualized rate of return provides a significant gain.
The bull put spread in VIRT is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy also has a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.