How Hedge Funds Use Options

Whenever I see trades that I’m not necessarily executing, but that I feel will give my Cabot Options Trader subscribers a feel for market tone, a trade idea or, if nothing else, a bit of options education, I email them a feature I call, “Stocks on Watch.”

Here is an options trade made on June 12^th which is a perfect example of how hedge funds use options, from a recent “Stocks on Watch”.

Stocks on Watch: Workday (WDAY)

As I’ve written several times in the last week, option order flow has turned mixed. In fact, all five days last week, bullish and bearish trades were split nearly 50/50. This, along with the many upcoming global events, has kept me from adding new bullish positions.

However, this morning a trader opened a massive bullish position in Workday (WDAY). Here are the details of the trade:

Buyer of 12,500 WDAY January 110 Calls for $23.70 – Stock at 126

This trade is interesting for a couple of reasons.

The $29.6 million of money at risk is clearly a large amount of premium bought. And is the largest single call buy that I can remember in the last month.

Also, with the stock trading at 110, this trader is buying deep in-the-money calls. So why would he pay such a high premium vs. buying calls at the 130 or 135 strike for significantly less?

The answer is all about leverage.

With this purchase, the trader risked $29.6 million in premium. However, he has big upside potential as he is buying-in-the-money calls, which will move almost one for one with the stock. If WDAY stock goes up $2, these 12,500 calls will go up nearly $2. He essentially controls 1.25 million shares because the calls are so far in-the-money.

If the trader wanted to have similar exposure through a straight stock purchase, 1.25 million shares would cost him approximately $157 million.

So the trader gets similar upside exposure to WDAY with the purchase of the calls, but with $127 million less at risk.

Typically traders execute this strategy if they have high conviction that the stock is going higher.

Choosing which expiration date and what strike to purchase when evaluating calls and puts can be overwhelming for beginner options traders. There are seemingly endless choices.

My general rule is that if you don’t have high conviction in a stock’s direction, buy slightly out-of-the-money calls/puts. This reduces your dollars at risk in case your stock thesis is incorrect.

And if you have high conviction in a stock’s direction, much like the WDAY trader, buy in-the-money or at-the-money calls/puts.

And in the past year we have seen similar deep in-the-money trades in Micron (MU), Alibaba (BABA) and Square (SQ). And buying in-the-money calls is a favorite strategy of legendary hedge fund traders David Tepper, George Soros, Carl Icahn and Warren Buffett.

This WDAY trade is what makes the power of options so intriguing. When you use options, you risk pennies to make dollars. Or in the case of hedge funds and institutions, millions of dollars to make many millions of dollars.

Jacob is a professional options trader and editor of Cabot Options Trader. He is also the founder of OptionsAce.com, an options mentoring program for novice to experienced traders. Using his proprietary options scans, Jacob creates and manages positions in equities based on risk/reward and volatility expectations. Jacob developed his proprietary risk management system during his years as an options market maker on the Chicago Board of Options Exchange and at a top tier options trading company from 1999 - 2012. You can follow Jacob on Twitter.