Why We Hate The Market But Love Google

Here’s the straight skinny: In the forty or so years we’ve been trading options, we’ve yet to come across anyone who has made money consistently by buying options on a bullish or bearish hunch. Because options are so knowledgeably priced, that’s akin to betting against the house. And any bettor who thinks he’s smarter than his bookie is bound to come out a loser.

The way around it is to always sell puts or calls against options you have bought. That is what we did about five weeks ago in Google (GOOG) when the stock was trading for around $750. Specifically, we told subscribers to buy the March 840-850-860 butterfly spread four times for 0.20 ($20).

This implied shorting two 850 calls while simultaneously buying an 840 and an 860. Our total risk, including commissions, was about $100. Although we are perennially bearish on the stock market, that doesn’t mean we always bet against it. Most of the time, we prefer to take long and short positions at the same time. In this case our bullish play in Google was balanced by a put calendar spread in the Diamonds that gives us cheap leverage if the market falls between now and June. Certainly not impossible. Our counterplay in Google was essentially a bet that if the stock market were to explode to new highs early in 2013, Google would lead the charge.

A Quintupler

And so it has. At yesterday’s peak, GOOG was up more than $90, or about 12%, since we put on the position. The stock’s steep rise has caused our butterfly spread to more than quintuple in value. It could have been sold yesterday for as much as $230, producing a theoretical gain of $840 on the four-spread position. At its theoretical maximum, with Google trading for $850 when the March options expire next Friday, the butterfly would sell for 10.00 (i.e., $1000) — a 50-fold gain over the 0.20 we paid for it.

In practice, however, we’ll be shooting for a comfy 3.00-4.00 ($300-$400) per spread, since the theoretical 10.00 is impossible to achieve. At that point we’ll have no skin in the came, since, at the suggestion of a subscriber yesterday in the chat room, we advised selling 25% of the position for 1.30 or better. Several traders reported having done so, more than covering their entire position risk. They now hold “free” calls on Google.