When 'stupid' trades are exactly that

optionMONSTER

When options of different strikes or expirations trade at the same time, we generally assume that it is spread of some sort--but sometimes it's just stupid.

Before anyone gets offended, we should note that a "stupid" is what the floor traders call it when a position doubles up on a directional bet, as opposed to spreading. So if a trader purchases calls at two strikes or two expirations, it is known as "buying a call stupid." (The same applies for puts.)

We don't see many of these, but occasionally they do come across our screens, as may have been the case yesterday when medical-technology company Stryker (NYSE:SYK) saw the June and July 60 calls trade at the same time. Although this may well have been a calendar spread , as we speculated in a recent Trading & Abetting audiocast, it did first appear to be a call stupid with both strikes bought.

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The reason we don't see many stupids drives at the heart of option usage: Most option traders, including professionals, have taken a definitive stand on buying or selling. They buy options to get long volatility and accept the costs of doing so. Or they sell options to collect premium and accept the " tail risks " that come with such positions.

In either case they have criteria about which options to choose. Option buyers typically go longer term to limit time decay, while sellers stay in the near term. If they are buying options on an individual equity, they are typically looking at a specific event or time frame. That is why stupids are unusual--they seem to indicate that the trader isn't decisive about the strike or expiration.

A third group of traders use spreads . They structure positions to hedge their costs, selling one option and buying another in vertical or calendar spreads. These hedged positions tend to limit time premiums --or use them to profit--while also limiting risk. (See our Education section)

Spreads are very popular trades with more advanced options traders because of these factors. They are especially useful when volatility is high or implied volatilities, while relatively low, are higher than the realized volatility of the underlying shares.

This latter situation is what we saw with the VIX at the time of the trade. The volatility index, then at 18, seemed pretty low, as it remained under the long-term average despite the recent decline in equity markets. But the 30-day historical volatility sat at 12.4 percent and the 20-day reading at 13.6 percent, so outright buying of volatility might not have seemed warranted. (See this Volatilty Sonar report)

At the same time, however, many traders are concerned about selling volatility given the current state of the world. This is why most choose to do spreads, not stupids.

(A version of this article appeared in optionMONSTER's Open Order newsletter of June 8. Chart courtesy of tradeMONSTER .)

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