"Options are a zero-sum game."
Top Post, Tue Apr 10 17:41:00 EDT 2001
By capcollett
- Taken from Juniper Networks (JNPR)
Remember, next week is option's expiration again. I have learned a critical lesson that I keep enforcing: options are a zero-sum game. There is a winner and a loser. When you buy a call there is someone who sells it to you. Sometimes that person is someone who is long common stock and wants to pick up income by selling a call.
Sometimes that person is someone who was long a call and sells it to you. But often the call is sold by someone who is betting against you. It is the latter that comes in to play in the last week. Those who sell calls because they want them to go down are in a pitched battle all week with those who want the calls to go up. And the battle has a conclusion, a bona fide ending that makes the battle get more heated all week.
There are winners and there are losers. There are people who are trying to stop you from making money and there are people who are trying to make money. There are people trying to tag you out, people playing defense. They need to stop you.
Why do they need to stop you? Probably because they are trying to make it up in volume. Let me explain. The people who sell calls for five-eighths of a dollar and three-quarters of a dollar don't make much on each one. But if you sell thousands of them and they go out worthless you have quite a payday.
Let's say that you have been selling calls regularly against this stock because the calls always go out worthless because the stock's been a dog. As you are typically selling a lot of calls each month, and they are all going out worthless, you have been picking up mucho dinero each expiration day. Sometimes, when the stock runs up to its upper end of the range, you think, hmm, maybe it is going to break out, but you see that people are willing to pay really juicy premium for the calls and you sell them. Then the stock recedes and you collect the gains when the calls go out worthless.
So you offer the April 40 calls for a few bucks. As do others, 1000 times. That means, you are offering the buyer the right to buy 100,000 shares of Juniper at $40 for $500,000. With the stock at $38 that seems like a pretty stupid bet to make. The guy who buys them, who is not dumb, bids you less. These markets are negotiable. You hold firm. You want to make $500,000 this week and you aren't going to sell them for less. The prospective buyer passes, as they are too rich for him.
But I hear about your offering, I hear it from a broker. I don't know anything about Juniper but I think the techs are due for a rally. This offering seems like an interesting speculation, or spec. I am looking for upside insurance against a big blowoff in the traditional stocks. I am thinking that the S&P is too oversold and the NDX is too overbought.
I am willing to take the gamble that this is the week that techs go up, the Dow explodes and I make some money in the old economy. I take lift your offering. In other words, I buy the 1000 calls on Juniper, with a week left. I love upside insurance. I want to give it a try. I am thinking the most I lose is $500,000 and when you and others like you are running $380 million that's not too much to pay for an insurance policy against an upside blowoff. Even if it goes out worthless in five days. Stranger things have happened.
The next day there is a seismic shift in the market. The tech stocks explode up along with the chemicals and basic industry stocks. Maybe somebody thinks the Fed will move. Maybe these stocks got too cheap. Maybe some price increase is sticking. Juniper jumps. The call seller is still oblivious. He is thinking this stock is so far from the strike, that he has nothing to fear. If he wanted to, he could always buy 100,000 shares of Juniper to protect himself. But that's a lot of capital he would have to expend. He could borrow the money and put the trade on but his risk reward is not so good. If Juniper drops back $10 he will have made $500,000 on the call but lost $1,000,000 on the common. If is drops more, it is an even bigger nightmare. Plus there is the nagging cost of carry. Most of the people who sell calls don't want to borrow money to finance common stocks underneath.
He could buy them back, of course, and take a loss. He could find some firm, some brokerage, that would sell him 1000 calls but he might have to pay 7 1/4 or $725,000 for them which is a huge loss. So he does nothing.
Wednesday the whole world changes. Real buyers come in to buy the tech stocks again. In the meantime, Juniper, which had a bullish earnings call, steps up and begins to buy back stock right under the buyers.
Making matters worse, Juniper is highly shorted. There are lots of people who have shorted, and they are being squeezed as it climbs higher. They keep coming in to buy it back forcing it up ever more. And new money is at last pouring in to buy these tech stocks.
It's Wednesday, at 2:00 p.m. and Juniper has broken out of the range. You are beginning to think, hmmm, I could be in a spot of trouble on those calls. Two days till expiration and this stock is breaking out.
But still you do nothing, because the calls, with two days left are still where you sold them to me. What are the odds that this move continues?
You do nothing. You gamble that this move can't be sustained. It would be a once-in-a lifetime move. If we could analogize to insurance this would be the Johnstown Flood for you. Once in a thousand years. You just don't think it is possible. You don't want to hedge against it. You let the short call position ride.
On Thursday, the market simply explodes. The Dow goes up 500 points. Tech stocks are just the rage. Three firms recommend Juniper and it opens up five points. You are now short a call for $5 that is at $13 and change with one day left. You are down $800,000 on this trade (you picked up $500,000 but now you have to buy them back at $13 and change if you want to, so $1,300,000 minus $500,000 that you picked up equals $800,000.)
You can't really handle that big a loss and you are beside yourself. You go into buy the common stock to hedge, and next thing you know, there are four other buyers and the company has stepped up its buyback even more.
You check the option market and it is the same as the common. You panic, just panic, and you say, to your broker, pay anything, anything, for 100,000 shares. You buy the stock at $52.
The pressure is now off. But you just lost $1,200,000 and you are out of business. All because you tried to make that $500,000 with a week left. You were part of a giant squeeze and you contributed mightily to it. This pitched battle happened millions upon millions of times this week. It led to the ramp we saw. It explains how options contributed to the run up.
That's why expiration played such a big role. Because these trades all had to end this week. The seller of the calls couldn't wait any longer. His number was up. He capitulated because he could not come in short 100,000 shares of National Gift on Monday.
Game over. Call buyer wins, call seller loses and the stock goes higher!
