Following the Tracks of Smart Money

In an age of information overload, you would think “following the money” in the stock market would be easier than ever. It’s actually harder. While we do have more access to market research than ever before, this maze of information has made it easier than ever for those with deep pockets to use the confusion to their advantage. Exorbitant sums of money are paid – not just to uncover hidden opportunities – but to also hide them from the rest of us. The public information we do have to make investment decisions is a mirage of best guesses, biased claims, and conflicting opinions.

The recipe to overcoming this challenge is simple: Follow not what smart money says, but what it does.

The Elephant’s Stampede: Buying in Bulk

Exactly what smart money is doing is concealed in new and creative ways every year, but it’s an imperfect process and often leaves tracks that we can uncover. That’s why we refer to smart money as “elephants.” For example, buying large quantities of shares in a particular stock creates visible volume spikes which indicate accumulation. So, the elephants often break up their orders, buying shares over the course of several days or weeks to stay undetected. It’s not enough to trigger unusual volume alerts, but still we can see it if we know what to look for—base patterns where buying comes in consistently right below the average volume. Here’s an example:

PANW Option Flow Block Trade

The Elephant’s Disguise: Option Flow

A more lucrative and discrete strategy is option purchasing. Options are contracts that give the buyer the right (but not the obligation) to buy or sell a stock at a specific price on or before a certain date. They are by nature more difficult and expensive to interpret in order to identify actionable trends, making them a perfect choice for disguising profitable bets.

There are two main types of option contracts: you buy “call options” when you anticipate a stock price will increase, and “put options” when you anticipate a stock price will decrease. By recognizing these option bets, you can position in the stock to profit from the expected price movement.

I’ll use a few examples below: Disney (DIS) for call options (where the price increased overtime) and PetsMed (PETS) and for put options (where the price decreased overtime).

Disney (DIS): Call Options and Future Price Increase

In DIS, we saw both volume and call options flow into the stock between June 15 – July 5, 2018; approximately $250 million in block trades and over $1.6 million in call options, respectively. Ironically, the news reported during this period was actually negative for DIS. Several reputable financial firms had slapped “neutral” and “downgrade” ratings on the stock. The general public was under the impression DIS was overvalued, and would thus decrease. But over the ensuing month, the price of DIS increased from $100 to $110. For those listening to the numbers not just the news, this was an opportunity for a 10% gain.

PetMed Express (PETS): Put Options and Future Price Decrease

In PETS, we saw put calls flow in between June 25 – 28 totaling over $2.5 million. Over the course of the next week, PETS dropped in price nearly 19% from $44.65 to $36.13 per share.

Cutting Through the Noise

Institutional option flow scanners can be expensive ($150/month) and I’ve found that many are not strongly filtered, with option chains cluttered by individual traders making smaller, and often conflicting bets. One of my favorite tools from TraderLion is that our scanner (used in the examples above) filters that excess noise and focuses on the large bets that really make a difference. I’d be lying if I said it didn’t make life easier.

Separating fact from fiction isn’t always easy, but it’s possible. The latest “news” and market opinion is seldom clear and rarely actionable, confusing all the more with smart money’s stealth tactics. But underneath it all, the pure numbers give us the ability to protect and grow our wealth. You just have to know where to look to follow the money.

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July 16, 2018