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How to Profit from Insiders: Part II

Monday, November 8, 2010 | Ed Pawelec

I wanted to finish up the article I started two weeks ago, but last week’s “Up/Up Indicator” event was simply too important not too share.

That being said, let’s go back to one of the most important events in my life as a trader -- an event that can teach us all several very important trading lessons ...

I could have lost $80,000 over night

Just to refresh the story from Part I: it was 1996.  I was just a few months into trading “for real”. 

I call it “for real” because I did spend some time with a market making firm where I was pretty much a monkey with a box ...  Standing on the floor, doing only what the little wireless box on a shoulder strap told me to do.  In other words, when the screen lit up on the computer, I was to buy or sell the prescribed number of contracts for my firm.  It’s pretty interesting how the whole process worked, but that's a story for another time.  The bottom line is that there was no thought involved in the order, nor did I have to manage the position once I made the trade.  No risk, no reward.  And the pay reflected that.

For “real” market makers -- the independents -- every decision they made impacted their position and their P&L.  Real risk, real reward.  The independent market maker’s earnings were a pure reflection of how well they managed that risk/reward trade-off.  That was the action I wanted a piece of!

The man who finally gave me the opportunity was not known on the floor as a home run hitter, but rather a trader who had done well relentlessly hitting singles and doubles.  Now I have nothing against home runs -- I am constantly looking for those opportunities -- but if a trader lives only by feast or famine, famine tends to get the best of you sooner or later.

So I was three or four months into real trading and looking at my first expiration week in which I had a real position to manage; it takes time to build a position.  I had four stocks in my book and was looking to add more.  Conrail, the phoenix of railroads, risen from the ashes of multiple industry bankruptcies in the 1970’s and a government takeover, was on the list. 

One of the reasons a market maker chooses to trade a stock is because of the flows.  Market makers make the spread by buying on the bid and selling on the offer, so the flow has to go both ways to make money.  I would never move to a pit just to trade Conrail, but since I was already standing there making markets in other stocks, it was a good addition.

So when the orders to buy those worthless upside calls started rolling in and I wasn’t in on the free money, I started getting worked up.  When I went to my boss, begging to get involved, he simply said that I should watch and learn.  There were many bosses who would have said, “Go ahead, get a piece if you can.” 

All I really wanted to do was sell 100 or so of the Oct 80 calls at $.25 -- remember, the stock was trading around $71, there were only 4 days to expiration, and the stock hardly ever moved!  There was no way this slow moving rail giant could move $9 in that time frame.  If nothing happened, as was to be expected, selling a hundred lot of the 80 calls would put an easy extra $2,500 in my pocket.

I have my boss to thank for not making what could have been a grievous error, possibly ending my career before it even began.  When the stock opened the next day at $88 on news of a takeover by CSX, that easy $2,500 would have become a massive $80,000 loss!

What a difference a day makes!

When you come that close to the blade of a falling guillotine, you notice.  If you walk away from an experience like that with just a smile because you didn’t lose your head, then you missed the point.  I was grateful, but I also witnessed firsthand a colossal mistake made by someone else that I could learn from.  It made me a better trader because I was now intimately aware of what is popularly known today as “tail risk” -- that slim possibility that a 4, 5, or 6 standard deviation move can happen and become a very harsh reality.

It also made me realize that, even as a market maker, you are at a severe disadvantage to someone with inside access or even simply superior research.  Hedge funds and institutions that want to take advantage of that edge go to the option markets to get the greatest leverage on their opinion or information.  I have seen it happen throughout my career -- big trades made by big money can lead to big profits.

While I began following these unusual events on the floor, I couldn’t really trade with the flows until leaving the floor.  Realize that, as market makers, we were paid to take the other side of any order that came to the floor, regardless of direction.  If you started buying the same option that big money was buying, not only were you dumping your risk on the other market makers, who you worked with everyday, but doubling that up by buying even more.  In other words, it was more than frowned upon by other market makers ... you simply didn’t do it.

Nonetheless, the day of the Conrail takeover made me alert to the possibility of following big money flows, a strategy that I look forward to sharing in Price Shock Trader.

Picking the flower from the rubble

As I have mentioned before, this was an important event in my trading career, and there are a few lessons we can ALL take from an "outlier" event like that:

1.  Don’t let your emotions get the better of you. This is, of course, the tried and true mantra of any successful trader, but Conrail was a real slap in the face.  I was so excited about the possibility of pulling down an extra couple of grand that I was completely blinded from the risks I would have been assuming.  Emotions and risk taking are simply not a good combination.

2.  If trades look out of place, take a closer look. Whether in trading or life, when something looks odd you have to ask yourself why.  This is particularly true when you have the opportunity to make a little money on the oddity.  Big money option flows provide free publicly available tips on when and in which direction a stock could move.  While not every one of their option trades are winners, a closer look at the underlying stock from a fundamental or technical perspective can open up some favorable opportunities.

3.  There is always someone who knows more than you about something.  I am always interested in hearing a new perspective or finding out some new information.  Whether having a conversation with a mechanic, a doctor, or an Indian Chief, I want to find out how people are thinking, hoping for a kernel of information that I might use now or stow away for future reference.  Since I can’t talk to the people making the big option trades, I have to work from the perspective that they know something I don’t.  That allows me to objectively search through other information to find something I may have missed and maybe capitalize on that.
I hope you readers have enjoyed my trip down memory lane, but I wanted to close with something more current.

WTI Up 65% ... What to Do Next ...

In mid October, Tycoon asked me to give them my pick for the fourth quarter as part of our “4 for 4” Special Report that many of you bought and read.  My pick was the purchase of the Jan 2011 7.5 calls in W&T Offshore (WTI).

Since then, the stock has jumped more than 30% and I have received some questions like, “What now?” 

Well, it will depend on what happens this week, but it’s definitely time to take some money off the board, and this is the beauty of trading the options instead of stock.  There was ample time to get into the Jan 7.5 calls for $4 or less since the recommendation was made.  If you did, it’s time to roll. 

I maintain my positive outlook on the stock, but realize it may need to settle in before it moves higher.  As of Friday’s close, the 7.5 calls were worth $6.60, so if you are in them you have a nice profit (65% or more).  If the stock pulls back a little this week, then the Jan 10 calls are the place to move to (Sell the 7.5 calls, lock in a few dollars and buy the same number of Jan 10 calls).  If the stock moves higher, then still sell the 7.5 calls to close, but buy the Jan 12.5 calls instead.  It is a matter of getting the best value with the greatest exposure to the stock, and the price action when you make the trade will be the determining factor.

Disclosure: The author is long WTI calls.

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Ed Pawelec
Contributing Editor
Price Shock Trader
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