Fin - Breakout - US

Anatomy of a Trade: When Trading a Panic, Let the Exit Come to You

Breakout

By Jon Najarian

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Welcome my friends, I am privileged to be asked to write the inaugural anatomy of a trade for Yahoo! Finance.

Our Style: Computer-Assisted Trading of Stocks, Options

Some investors want to do fundamental analysis to determine a company's value. Other investors use technical analysis.

My brother Pete and I, on the other hand, are nearly always driven by our work as forensic investigators of trading activity. Whether that activity is stock buying or selling, option buying or selling or futures buying or selling, our job is to find which side of the trade, bullish or bearish, the institutional money is on.

We determine this by sophisticated algorithms and multiple high-speed Internet connections, capable of pulling data up to 600 times faster than a T-1 connection. The reason this is so important to us is that presently high frequency trading has accelerated trading to the point where our computers routinely track over 1 million quotes per second. With data coming in that fast, it is literally like trying to take a drink from a fire hose. The dataflow is simply too fast, making it impossible for anything but a computer to determine whether a trade occurred on the bid or on the offer.

But this is our niche and our passion. We aim to find the patterns of buying or selling within the innumerable data points and invest in those institutional fast money trades that are so cleverly and easily concealed within the 1 million-plus trades per second that stream from the floors of the U.S. stock, options and futures exchanges.

The Situation

A week ago Friday Japan suffered a horrific natural disaster -- the one-two punch of a magnitude 9 earthquake and subsequent tsunami. While we mourned the loss of life, from a trading perspective we also immediately knew that insurance companies would be among the first casualties. But seldom are the obvious trades the best trades.

While fundamental traders examined the short-term and mid-term effects and technical traders looked at charts to see where likely support would be under the markets, Pete and I examined our computer screens for those unusual buying patterns that are tip-offs for where the institutional money is being committed.

We saw several very large blocks of stock trade on the bids of Toyota (TM) and subsequent large put option accumulations in the car maker. The volume of puts trading that first Friday in Toyota topped 5,700, or more than 10 times the turnover from Monday of the same week.

The Entry

We figured the traders that bought those puts in big numbers knew what was going on with the company and the country far better than we could, so we followed them into the puts.

The drop from last Thursday prior to the earthquake and tsunami was a mere 2.1 percent sell off from $87.52 to $85.65, but our work showed big investors -- that we refer to as smart or fast money -- were betting big that Toyota would have considerably more downside.

Then over the weekend, as nuclear reactors at one of Japan's biggest power plants began to overheat, the decision was made to basically scuttle the plants by introducing sea water into the reactors. While this was a terribly difficult decision, it effectively wrote off the multibillion dollars invested in the reactors.

The drop in shares of Toyota on Monday accelerated along with that horrible news, as many investors used stocks like Toyota as a surrogate for the Japanese markets. The fall on Monday took Toyota from $85.65 to $81.73, a 5.7 percent decline.

The trading in puts exploded on that huge drop, as people sought protection against further declines in Toyota's shares. Our computers showed over 22,600 puts changing hands, more than 22 times the amount of the previous Monday prior to the disaster.

Toyota's shares in the U.S. trade an average of 695,000 per day. But on Monday March 14, over 3.6 million shares changed hands. The combination of massive put trading and volatile stock trading was screaming that we were nearly at a capitulation, that time of panic and fear that typically follows events such as natural disasters, litigation losses or substantial earnings misses. Just as the earth warns us with tremors, so too do markets warn us with extremely unusual buying or selling.

I had focused on the Toyota April 80 puts. These puts nearly doubled from Thursday's price (March 10) of 65 cents to $1.20 on Friday as the quake and tsunami news hit. These puts give the owner the right, but not the obligation, to sell Toyota at $80 until the third Friday of April -— the options expiration date.

The Exit and Outcome

As news of the disaster grew more dire over the weekend, and the Japanese market declined further, the April 80 puts exploded to $3.30 on Monday as nearly 44 times the normal volume of puts changed hands. Then, Tuesday evening, as the Japanese market fell 16 percent before rebounding to a loss of 10.5 percent, I elected to buy stock against my puts, covering shares in the $76.50 range.

As the options opened for trading on Tuesday the stock rebounded to $81, closing at $81.73. By closing shares purchased for $76.50 at $81, and closing options I had purchased for $1.15 at $5, the collective profits on the trade would be $4.50 on the stock and $3.85 on the options -- that's a total of $8.35 on that initial investment of $1.15. In this case, the return on an absolute basis would be $7.20 (after my purchase costs) or more than six times the initial investment.

It is important to note that the purchase of stock, even if closed in the same day, would tie up $76.50 per share, or if margin was used, at least $38.25 to support the purchase of the stock.

The Takeaway

If you are an investor who doesn't have access to premarket trading and/or enough capital to purchase stock against your long puts, you could wait until the market opens for options trading (9:30 a.m. ET) and trade out of the puts at that point.

Obviously the return would suffer given the missed opportunity to scalp the stock, but you'd still have turned $1.15 investment in those April 80 puts into $5, and that's not too shabby for a limited-risk trade.

About the author:

Jon "DRJ" Najarian -- Co-founder, optionMONSTER and CNBC Contributor

Jon Najarian is a professional investor, noted media analyst and speaker, and cofounder of optionMONSTER. Following a brief stint as a Chicago Bears linebacker, Jon launched his financial career at the Chicago Board Options Exchange (CBOE) in 1981, trading in the pits for some 25 years. In 1989 he founded Mercury Trading, running the company for 15 years until 2004, when he sold his floor-trading operations to Citadel, one of the world's largest hedge funds.

More recently, Jon -- often known after his CBOE floor call letters "DRJ" -- has developed and patented trading applications used to identify unusual activity in stock, option and futures markets, notably the Heat Seeker program, which uncovers extraordinary buying patterns from among the 180,000 quotes per second that stream from America's stock, options and futures exchanges.

In addition to optionMONSTER.com, Jon's research and analysis is widely cited by leading financial media including The Wall Street Journal, Barron's, Reuters, Bloomberg, Dow Jones, FOX News Channel, CBS Radio and CNBC. Jon is a CNBC contributor, hosts a CBS Radio show, and webcasts twice daily on CBOE-TV.

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