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Exploit the Market Makers

ByMark Sebastian, TheStreet's OptionsProfits Team

Most traders like to look at the big names: Apple , Google and IBM to find their trades. That is certainly a great way to trade. I, for one, have found that buying and selling AAPL volatility can be a great way to produce income. That said, I think it is almost easier and more profitable to find a small company that no one has heard of and exploit the market makers.

Many electronic traders think market makers really know what is going on with their stocks. But consider this. In the equity world, it can be one guy managing hundreds of small name stocks at once. Certain stocks can slip through the cracks, or simply get mispriced. This especially happens when there is one player that throws his or her weight around. This is what I saw in iStar Financial .

The real estate finance firm has had almost a 1000% increase since hitting its lows during the 2008-2009 crises. Since that time, the stock has crept up and moved with the stabilization in the commercial real estate market. Now that the company is about to break $10.00 ($9.88 as of 2:25 p.m. EST) and pays a nice dividend, the stock could start attracting interest from institutional buyers.

At the same time, just as the stock is about to attract some real buyers, the implied volatility of the options is sitting at two-year lows (and is much lower than the last time SFI began to threaten $10.00). This is likely the driver of all of the call buying we are seeing in the stock. Customers have bought the March 10/11 call spread for around $0.50, 3,000x, while another customer bought the July 10/13 call spread for $1.00. In another bullish sign, a trader sold the January 2012 5/7.5 put spread collecting $0.55 for it.

I really like two of the three trades. The put sale at implied volatilities this low with downside skew as steep as it is might not be my favorite trade, but the two call spreads appear to be very favorable. Interestingly, the July 10s and 13s appear over price relative to the 11 and 12 calls. It could be the market makers are trying to goad foolish traders into selling them cheap volatility. We are smarter than that (at least that is what my mom tells me). By simply adjusting the strikes we buy and sell, I think we can produce an even better trade than the July 10/13 call spread in SFI.

By purchasing the July 11 calls over the 10s, we can initiate a trade that has very similar characteristic but costs less in relative terms.

Trade: With SFI trading at $9.95, buy to open SFI July 11 calls for $0.90 and sell to open SFI July 13 calls at $0.45. At the time of publication, Mark Sebastian held no positions in the stocks or issues mentioned. Mark Sebastian is COO and Director of Education for Option Pit Option Mentoring. Sebastian is a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange. Along with his role directing the path of education for Option Pit, Mark is currently the Director of Risk for a private hedge fund. He started the popular blog Option911, which is now the Option Pit blog. Sebastian has been published nationally on Yahoo! Finance, is a featured contributor for TheStreet's OptionsProfits, SFO, OptionsZone and is the managing editor for Expiring Monthly: The Option Traders Journal. Mark has a Bachelor's in Science from Villanova University. OptionsProfits For actionable options trade ideas from a team of experts, visit TheStreet's OptionsProfits now.

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