Options Activity

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Options Activity: A Market Indicator That Always Delivers Outsized Gains

by Louis Basenese, Advisory Panelist
Associate Investment Director, The Oxford Club
Friday, August 01, 2008: Issue # 831

We all know the adage, “There’s no such thing as a sure thing.” And it’s especially true when it comes to investing. But for me, one indicator comes darn near close…It’s not insider buying. Sure, company executives forking over millions of dollars to purchase their own stock – like Aubrey McClendon of Chesapeake Energy (NYSE: CHK) continues to do – is decidedly bullish. And exhaustive research bears this out.

A recent study by Morgan Stanley found companies with heavy insider buying outperform the S&P 500 by an average of 13.7%. But here’s the rub: Because of strict SEC laws and the fact that insiders tend to be the longest-term investors out there, a considerable lag usually exists between the purchases and meaningful price appreciation.

The indicator I’m referring to is not an announcement about a massive stock buyback plan, either. Here, too, the data favors long-term investors. Companies that announce stock buybacks often outperform the broad market over a four-year period by a margin of 45%, according to studies out of the University of Illinois at Urbana-Champaign.

But again, it can take months or years to recognize the above-average gains. Blame it on our instant gratification culture, but I prefer an indicator that often delivers outsized gains in a few weeks, days, or even a few hours. So what is it? Why, none other than options activity…

Options Activity – The Holy Grail to Lightning Fast Gains

Abnormal – and lopsided – options activity. Ridiculously lopsided. Like we witnessed Wednesday with EMC Corporation (NYSE: EMC)…

Wednesday, more than 300,000 August $15 options traded hands. That’s 17 times the average daily volume. And the activity was unmistakably lopsided. Call options buyers outnumbered put options buyers by more than three to one.

Investors are certainly banking on a major rally in the next two weeks. And as options expert Jon Najarian put it, “I can’t remember seeing a frenzy like this.”

So let’s dissect these bets to fully understand why this is so bullish…

For the call buyers to make money, they need the stock to move above $15… in only two weeks.
Based on Tuesday’s closing prices, that means EMC would need to rally approximately 12% for these investors just to break even.
No small feat given the time constraints… and the fact EMC already reported earnings. You see, it’s not unusual to see increased options activity preceding earnings announcements, as investors try to front-run a strong or weak report.

But there’s no known catalyst looming on the horizon for EMC. So in Vegas terms, these options purchases appear to be sucker’s bets. So why would so many institutional buyers be so foolish?

Large-Scale Options Activity – Not Retail Investors…

By the way, I know retail investors weren’t behind the options activity because the options contracts were being purchased in blocks of 5,000 to 10,000 contracts, equivalent to trade sizes of $200,000 to $400,000 based on the average contract price yesterday.

Put simply, they’re not stupid. They know something…

Research out of Yale University on abnormal call options volumes strongly suggests they know a takeover is afoot. (If you’re interested in all the findings, the study is titled “Informational Content of Option Volume Prior to Takeovers.”)
If so, EMC would rally big time on the announcement. Takeover premiums historically average 22%… and in recent history they’re higher, closer to 40%.
No doubt, a 20% to 40% move for EMC’s stock would make the $15 call options much more valuable.

Options Activity Suggest Likey Suitor for EMC

The options activity certainly suggests that EMC is about to get bought out, with networking giant Cisco Systems, Inc. (Nasdaq: CSCO) the most likely suitor.

Here’s another, and in my opinion, more likely outcome. EMC is getting ready to announce a takeover or sale of its 85% stake in VMware, Inc. (NYSE: VMW).

And that could be just as bullish…

Recall, EMC owns 85% of VMware. That was a great thing when VMware went public at $29 and quickly ran up 333% to $125.25. (A move subscribers to my Hot IPO service got a piece of, booking a 40% gain in just 14 days.) It brought EMC right along for the ride.

Then Microsoft and Oracle aggressively entered the virtualization space. And the added competition cut the knees out from under VMware, with shares now languishing around $35. Naturally, EMC’s stock followed the misfortunes of VMware.

But most agree EMC’s been overly punished. And a quick way to remedy the situation would be to sell its 85% stake in VMware to the public… or a cash-heavy competitor. As we know, Microsoft and Oracle don’t exactly lack cash or shy away from acquisitions.

So, when can we expect an announcement?

Options Activity Points To An EMC Announcement

Well, if it’s going to happen, the options activity is betting it will come in the next 15 days. And that’s possible. EMC is set to present at the Pacific Crest Securities technology conference in Vail, CO on August 4. They could make an announcement then. Especially since it’s a Monday and most takeover announcements come on Mondays.

But no matter when an announcement comes, here’s what’s important…

When I see ridiculously lopsided options activity like yesterday with EMC, I get excited. It’s the surest indicator I know of.

As Benjamin Franklin once observed, “Three can keep a secret, if two of them are dead.” And when we see abnormal options activity, we know nobody’s dead… and that the secret is out. Make no mistake, insiders positioned themselves to profit off EMC before this secret is made publicly known.

And we might want to join them.

To be clear, this ranks as a speculative trade. So if you decide to act on the surest indicator I know, you’ll want to ratchet down our recommended position size of 4% to 1% (or less).

And play it one of two ways…

Option 1: Simply buy the stock, using a 25% trailing stop. And wait for the news to break.
Option 2 (more risky): Be like the professionals and buy the $15 call options. If you choose this route, at least increase your odds of success by going with a later expiration date. Say, the October or January 2009 calls. It will cost you a little more, but if the insiders are right about a big development and just wrong about the timing, you still make out like a bandit.

Good investing,

Louis Basenese

P.S. Next week, I’ll share with you my favorite SEC form to consistently uncover double- and triple-digit profits, while the rest of Wall Street remains clueless. Stay tuned.

Editors Note: To get all of Lou’s trades via e-mail, just sign up for his Takeover Trader service. He’ll send you specific recommendations to buy the market’s most appealing takeover targets – companies with rock-solid fundamentals and substantial growth prospects. (Shares of these firms tend to outperform the market even if a takeover is never announced.)

Today’s Investment U Crib Sheet

To find out the volume on a particular options contract, you can look at any number of sites that quote stock options prices. Using CNBC’s stock quote site, enter the stock symbol and select “Go.” Then select “Options Chain.”You’ll see the contract expiring soonest – divided into calls and puts, and the volume on each.

To find out more about using call contracts, and the power of leverage options can give you, check out Investment U Issue #607, Selling Call Options: How To Instantly Turn Your Stocks Into Passive Income.