Stop Guessing: Follow the Real “Smart Money”

In trading, “smart money” is a commonly used term. Typically, this is a way to demean retail traders, suggesting that because they are less sophisticated than large institutional traders, they are the dumb money.

But the true “smart money” is armed with more than institutional tools and sophisticated research; they have inside information. Inside information can be news about mergers, acquisitions, pharmaceutical trials, upgrades, downgrades, or large purchases. In that sense, they have tomorrow’s newspaper today. And with that, they can make some real money.

So how do we trade on what they know without actually knowing the same information they do? Follow the “smart money” by identifying unusual option activity that occurs in the market on a day-to-day basis. If we know what footprint they leave, we can follow them without having full information.

Here’s an overview of what “smart money” trades look like.

1. Smart money uses outright calls or puts.

If you knew something good was going to happen to a company that sent its stock price higher, what’s the most capital efficient way to capitalize on that news? Buy an outright call. If something bad were going to happen, you’d buy a put.

Sure, there are other ways to play an increase in stock price (you could sell a put, for example), but that would require more capital and would limit your upside to the sum of the credit you received. If you are trying to make a pure play on the stock moving higher, you are going to buy an option. Unlimited upside or downside and a limited capital outlay.

2. It buys options on the offer.

If you and I run two separate market-making firms, then our pricing models may differ. But it’s likely that they differ by a few pennies.

If, on the other hand, I know something you don’t, why would I argue over a few pennies and risk that I can’t get into a trade? I am looking for a position to increase by 5-10x… so what’s a few pennies between the bid and the offer?

So more than any other order, the smart money is likely to buy options (in good quantity) and to pay up for them.

3. It buys short-term options.

Option pricing models take a number of things into account, including interest rates, the strike price, the stock price, its volatility, and the time to expiration. In short, all else being equal, the longer the time to expiration, the higher the option will cost. This should make intuitive sense: there is more potential volatility between now and three years from now versus now and next month.

So, if I know something is going to happen next week, then why would I pay up for that extra duration? It’s money that I am paying that I won’t fully realize.

In addition, the delta on long-term options at the same strike price are not as high as the delta on short-term options. What that means is that for every $1 the stock price moves in my direction, short-term options will gain more in price than long-term options.

All this combines to make the case that the best returns are going to be in short-term options.

4. Smart money prefers out-of-the-money options.

Options have intrinsic and extrinsic value incorporated into them. Intrinsic value is the value that the option has if it were exercised right now. Extrinsic value is the value in an option because of uncertainty (volatility, time, etc. as listed above).

Let’s suppose a stock is trading at $50 and the $45 1-month call is trading at $7. What this means is that the option has $5 of intrinsic value in it and $2 of extrinsic value.

An option that is trading out-of-the-money has $0 of intrinsic value. That means that it will be cheaper than an option that is in-the-money. If the $55 option is trading at $1, I can buy 7x as many as I could of the $45 calls with the same capital outlay.

If the price rises to $60 at expiration, my $55 option turns $7 into $35, while the $45 option turns $7 into $15. My return-on-capital is magnified because I chose the out-of-the-money option.

And that’s just the type of bet that “smart money” makes.