Why Analyzing ETF Action Is Tricky

 |  Includes: GLD, MDY
by: optionMONSTER

By Chris McKhann

Why doesn't optionMONSTER write more about ETF options? One reason is that even if we can figure out exactly what they are doing in a given trade, it is possible, and in some cases probable, that the trading is part of something larger that may have different -- or even opposite -- implications.

I have to laugh when I see websites that publish the holdings of big hedge funds, especially quants or statistical arbitrage funds. Looking at such funds' long holdings (which what they are obligated to publish) may lead one to think that the trader is bullish on certain names. But by the time the information is public, the holdings may be entirely different.

I recently read just such a post regarding Renaissance Technologies. Now that is a firm anyone would want to follow, as it is arguably the best hedge fund ever. But it is largely a statistical arbitrage ("stat arb") firm. That means that it is not betting on the direction of a given stock, but on the relationships between different instruments.

So if the firm buys XYZ stock, it is very likely that it did so at the same time it sold ABC. So its managers actually don't care if XYZ climbs, as long as the spread between the two instruments closes. That can happen in three ways, and only one of them requires XYZ to climb. ABC can fall while XYZ is unchanged, or ABC can simply fall faster than XYZ.

This same problem comes up in the options realm. If a trader buys a bunch of puts on the SPDR Gold Shares (NYSEARCA:GLD) exchange-traded fund, on the surface it would appear to be a bearish move. But it could simply be a hedge on long GLD shares.

I use this example because this ETF is reportedly the largest holding of two giant hedge funds, one holding as much as $4 billion worth. Puts combined with long shares is a "synthetic call" position and is therefore bullish.

Beyond that, many of the funds that focus on options use some form of relative-value strategy. Much like stat arb, they are buying one set of options and selling another. This may be a "pairs trading" type of strategy or "dispersion trading," meaning that they are trading the volatility of an ETF against the volatility of the underlying names. Determining those types of trades is almost impossible.

In August we saw a good example in the S&P MidCap 400 (NYSEARCA:MDY) exchange-traded fund. A trader bought 4,000 of the September 135 calls for $3.05, with shares at $132.75. A week later the MDY was down to $129.64 and those calls were trading at $1.50.

We could assume that the trader had lost money. But if it was done as part of a larger strategy, the trader might still have made money overall.

I bring this up to explain why it is tricky, at best, to follow the "smart money" when it comes to long stocks or ETF trades. It is much easier to obtain a relatively clear picture when it comes to options on individual equities. When traders have a strong belief in a particular name -- be it special insight or insider knowledge -- they usually turn to options on that name to get the most bang for their buck.

It is ironic that firm conviction and the desire to get the biggest relative return drive people to the option market just as surely as the need for protection does. It is a wonder that there are people who spend the time and money to trade but don't use options in both ways.

Disclosure: No positions