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July 5, 2006

The Story with Paper: It's more than meets the eye

By Mark Longo

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  • The Story with Paper: It's more than meets the eye

Appearances can be deceiving. Options professionals spend the majority of their day thinking about paper. In fact, paper is the key to almost everything in this business. What sort of paper has the power to mesmerize traders, brokers and exchanges alike? This paper isn't money, nor is it some sort of mystical trading document. Instead, it's the

industry's codeword for the large institutional customers driving order flow.

Professionals know that, if they want to understand what's going on in an options product, they must know what paper is doing, which reflects institutional activity. It's just a fact of life in the options world.

As one might expect, the market moving power of paper has also captured the attention of the financial media. Unfortunately, some vital information has been lost during the conversion from the options markets to the business page.

Given the dearth of options coverage in the financial press, some believe that any attention on the options markets is a good thing. However, superficial options coverage is a potential hazard. In fact, certain aspects of this coverage can be bad.

So Misunderstood

It's not uncommon to open a financial publication these days and find an update about unusual activity in XYZ calls or XYZ puts. This coverage in and of itself is relatively harmless. However, when these articles are accompanied by suggestions that certain options activity can indicate the direction of the underlying security, then the coverage can be harmful.

The prevalence of these types of articles, and their undue influence on equity traders, is an example of how a little knowledge can be dangerous thing.

After all, if there is a large amount of call buying in a particular option, then paper must think the stock is going up. Right?

One of the vital facts that has been lost during the translation to the business page is that options professionals think about trades in a manner that is different from those outside the business. This difference, however, can be difficult for experienced equity traders to understand.

Without delving too deeply into arcane topics like volatility skew and put/call parity, let's just say that options are not stocks and they can't be looked at in the same manner. When someone buys a stock, his intentions are relatively straightforward. However, options are more nebulous. One key difference is that options are not a zero-sum game. Depending upon how options positions are hedged, both sides of a trade can be winners.

Another problem lies in perception. While those outside the business tend to think of options trades in terms of calls and puts, these are merely abstract distinctions to experienced options traders. Instead, options traders tend to focus on long and short positions on individual strikes.

This style of trading often leads to scenarios that are counterintuitive to the average securities professional. One such anomaly is when options traders are long thousands of calls but they still want the underlying stock to drop. Unfortunately, these nuances are lost on many outside the options business. That leads some to assume correlations where none exist.

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