Yesterday in Cabot Options Trader, we initiated a new position in InvenSense (INVN) following several weeks of call buying. The call buying was focused on September and December expiration cycles, and because of this we bought December calls. The trade in INVN was similar to the trade in ABBV in that we were “overpaying” for the option. Some Cabot Options Trader subscribers have asked what this means.
For example, the market on INVN December 17 Calls yesterday was $1.50–$1.70. The market is $0.20 wide, and in theory the option is likely worth $1.60. This means that the market maker has $0.10 of “edge” when he buys the call for $1.50, and $0.10 of edge when he sells it for $1.70.
In contrast, if you were to take a look at the options in stocks such as General Electric, Bank of America, or Pfizer, the market on calls might be $0.99–$1.01. Theoretically, the market maker has $0.01 of edge when he buys and sells this option.
So why the difference in width of options one stock to another?
First off, option liquidity is a major issue in a stock like INVN versus GE. On average, GE trades close to 100,000 options per day. INVN on the other hand, only trades a couple thousand contracts a day. If a market maker sells 10,000 GE calls to a hedge fund, he could immediately buy back 10,000 and reduce risk. This would be a much bigger challenge in INVN as the markets are wide, and the most you could likely buy at one price would be closer to 200 contracts.
Likewise, stock liquidity plays a major role. GE trades an enormous amount of stock per day and the stock is rarely volatile. A $0.25 daily move in the stock is a fairly large move. INVN, on the other hand, trades significantly less stock and bounces around $0.25 to $0.50 several times a day. Because of this lack of liquidity, it’s also hard for a market maker to hedge when selling calls. For example, if I bought 1,000 calls from a market maker in INVN, to properly hedge this theoretical trade, he might have to buy 50,000 shares. This would be a big challenge as the stock is often bid and offered for only 500 shares, and the market on the stock is often $0.10 wide.
The time until expiration is another key component to the option width. For example, it’s easier to predict potential stock-moving news when pricing an option that expires in July. Does the company have earnings this month? Are there large macro events this month that could affect the stock? However, in direct contrast, it’s more of a challenge when pricing options that expire in December. For a December option, there will likely be two earnings announcements between now and then, and there is always the potential for corporate action such as a takeover or spinoff. Or the market could simply sell off, or rip higher before then, which would also likely affect the stock.
While I say we are overpaying when buying an illiquid option with a longer duration, in reality perhaps we’re not. We recently bought the ABBV January Calls for $3.60. At the time of the trade, the market on the calls was $3.10–$3.60, so we were likely overpaying for that option by approximately $0.25. However, in reality, we may not have been overpaying as perhaps the market maker was pricing the option too cheap in volatility terms, or not properly pricing upcoming news. So far “overpaying” for that option has worked, as we locked in a nice profit on half the position, and the stock is again trading higher today, just below its 52-week high.
As I highlighted in my Monday morning Cabot Options Trader write up, more and more big trades recently have been focused on longer durations such as September and December. And we have been focusing our attention on those longer durations as well, hoping that it will take out the daily gyrations on Greece and interest rate fears, etc. This allows me to not get too wrapped up in daily price swings, and to have a longer-term perspective when evaluating a position. Also, focusing on longer duration trades will help lessen the decay that has the potential to be overwhelming if this turns out to be another low volume and low volatility summer as has so often been the case.