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How Hedge Funds Use Options to Gain Leverage

Want to know how the hedge funds use options? Here is an example of how one big institutional trader spent $132 million on three technology stocks.

Hedge Hedgehog Hedge Funds

Hedge funds have been using options to get market leverage for years. Warren Buffett has been known to buy calls and sell puts to get bullish exposure, and so has Carl Icahn.

Whenever I see trades that I’m not necessarily executing, but that I feel will give my Cabot Options Trader subscribers a feel for market tone, a trade idea or, if nothing else, a bit of options education, I email them a feature I call, “Stocks on Watch.”

Here is a sample of how hedge funds use options, from a past “Stock on Watch.” I’ve used faux stock symbols here since these numbers are no longer accurate.


How Hedge Funds Use Options

Stocks on Watch: XYZA, XYZB and XYZC

“This morning, a trader added massive bullish options positions in three technology stocks. Here are the trades:

“Buyer of 33,000 XYZA September 40 Calls for $16.85 – Stock at 54.7 ($55.6 million of premium purchased)

“Buyer of 50,000 XYZB September 39 Calls for $7.85 – Stock at 44.2 ($39.2 million of premium purchased)

“Buyer of 5,000 XYZC September 340 Calls for $75.10 – Stock at 380 ($37.5 million of premium purchased)

“Because the trades are all big premium targeting the same expiration cycle, I can safely assume one hedge fund or institution initiated these positions. Net, he purchased approximately $132 million worth of calls in early trade today.”

One appealing aspect of my trading services is that readers have access to me via email. I typically respond to questions in less than an hour. And if a subscriber brings up a great question, one that I think would benefit the entire group, I share the question and my answer with all Cabot Options Traders. Here is an example:

“Following my ‘Stocks on Watch’ email this morning highlighting big call buying, I received a great question: ‘What is the logic behind buying calls so far in the money? I just don’t understand why anyone would do that, although I’m sure there must be a good reason.’

“The answer is all about leverage.

“To explain, I will focus on the XYZA trade. Here were the details:

“Buyer of 33,000 XYZA September 40 Calls for $16.85 – Stock at 54.7

“With this purchase, the trader risked $55.6 million in premium. However, he has big upside potential as he is buying-in-the-money calls which will move almost one-for-one with the stock. If XYZA stock goes up $2, these 33,000 calls will go up nearly $2. He essentially controls 3.3 million shares because the calls are so far in the money.

“If the trader wanted to have similar exposure through a straight stock purchase, 3.3 million XYZA shares would cost him approximately $178 million!

“So the trader gets similar upside exposure to XYZA with the purchase of the calls, but with $122 million less at risk.”

Making Options Trading Low-Risk

This is what makes the power of options so intriguing. When you use options, you risk pennies to make dollars. Or dollars to make thousands of dollars.

What else would you like to know about how to use options to gain leverage?


*This post is periodically updated to reflect market conditions.

Jacob Mintz is a professional options trader and editor of Cabot Options Trader. Using his proprietary options scans, Jacob creates and manages positions in equities based on unusual option activity and risk/reward.