Justin’s note: Today’s essay comes from master trader Jeff Clark.
Jeff’s one of the best traders I’ve met—and his track record can attest. Since 2005, his subscribers have had the opportunity to make triple-digit gains over 50 times and double-digit gains more than 160 times.
That’s why I read his market analysis every morning. And sometimes, Jeff also shares some of the best stories from his career. His latest was so good, I had to share it with Dispatch readers…
By Jeff Clark, editor, Delta Report
In February 2000, I spotted an irresistible option trade.
It was a no-brainer – almost as if the guys on the option trading floors were holding up signs announcing "FREE MONEY."
So, I backed up my wheelbarrow and loaded up.
It was the most profitable trade of my career… But it almost bankrupted me first.
The story is 17 years old, and my memory isn't what it once was, so the finer details may not be exact. But here's basically what happened…
PALM, the maker of smartphones and other handheld technology products, was scheduled to go public on March 2, 2000. The company was a wholly owned subsidiary of 3Com – which was issuing about 20% of the company to the public and taking advantage of the insane valuations of the internet mania.
The IPO price was set at $38. Of course, we all knew the stock would open for trading way above that level because, well… that's just what stocks did back then.
In January 2000, shares of 3Com were trading at about $50. By the last week of February, they were crossing the tape at more than $90.
The market was already pricing in the increased valuation of 3Com shares as a result of the PALM IPO. In the option markets, the expectations had risen to purely foolish levels.
The 3Com March $120 call options were trading for about $6. In other words, call buyers were willing to pay $600 for the right to buy 100 shares of 3Com at $120 per share over the next four weeks.
3Com was trading at $90 – already up 80% in the past month! It would have to go up another 33% in the next four weeks for these calls to be worth anything at all by the time they expired.
Sellers of the call options would receive $600 for each contract and would be obligated to sell shares of 3Com at $120 if the stock was above that level on option expiration day.
The pricing of these options was just nuts, and it was the result of tremendous hype surrounding the PALM IPO – hype that would disappear as soon as the stock went public.
I did the only thing I could do… I sold the call options and collected $600 on each contract. In fact, since the premium was so large and the potential for profit was so high, I took a position that was about three times my normal size.
And the hype continued…
The next day, just three trading days before the PALM IPO, shares of 3Com rallied to $95, and the option premiums inflated further. The March $120 call options, which I had sold the day before for $6, were now trading at $10. I was down $400 per contract in just one day.
So, I sold more.
That's right. I increased my position size even more. Not only that, I started telling my clients about this trade and encouraging them to take positions. I even put my own brokerage firm's money into the trade. I was THAT certain it would be a winner.
3Com went higher the next day, too. It was now at $96 per share, and – in a further display of the power of hype – the March $120 call options went up more than the stock. The options I sold at $6, and then again at $10, were now at $14.
I sold more. I also started selling the March $130, $140, and $150 calls as well. The option premiums were just too large not to. And the probability of the stock rallying above $120 (let alone $130, $140, or $150) was so remote that I rationalized it was OK to keep the exposure.
Then came the morning of the PALM IPO.
I hadn't slept at all the night before. I was sitting at my desk and staring through an assortment of half-empty Pepto-Bismol bottles at the television screen on the other side of my office.
Maria Bartiromo and Bob Pisani were on CNBC. They were talking about the tremendous interest investors had in the PALM IPO. Early indications were that PALM – which was priced at $38 for the IPO – would open for trading somewhere north of $150 per share.
My stomach sank, and I slammed my forehead onto the top of my desk.
If PALM was worth $150 per share, then a quick "back of the napkin" calculation told me 3Com was worth more than $300 per share.
I had agreed to sell it for $120. My exposure was so large that anything above $180 would bankrupt me. It would wipe out my account, put my firm under the minimum net capital requirements, and create huge losses for my clients.
I started to panic. I started typing an order to cover the position and take the loss while there was still time. 3Com was trading at $105, and the March $120 call options were $18. It would be a tough loss to swallow, but I'd remain solvent, and I'd be around to trade the next day.
Just as I finished typing the order and was about to hit the "send" key, I stopped. A voice in the back of my head said, "It's all hype. You've seen this before and you know how it's going to end. You used logic and common sense when you got into the position. Now you're about to panic to get out."
I erased my order entry screen. Stood up from my desk and unplugged the television. I then left my office for two hours.
PALM started trading about one hour later. It opened at $140 per share, the high of the day, and then began drifting lower.
3Com never traded above $110. And as soon as PALM went public, 3Com started to sell off. It was a typical, and predictable, "sell on the news" situation.
When I returned to the office, 3Com was trading at $85 and the March $120 call options, which I had sold for $6, $10, and $14 – and which had traded as high as $20 earlier in the day – were now worth just $0.06. Every contract I had sold for a minimum of $600 now cost just $6 to buy back…
The trade that had threatened to bankrupt me just a few hours earlier had now made a fortune. My clients were rich. My firm was rich. And my own net worth nearly doubled as a result.
I shut my office door, turned off the lights, sat down at my desk, and closed my eyes. And I swore I would never, ever do that again.
There's no need to.
The option market provides any number of ways to take advantage of mispriced, overhyped situations without exposing yourself to tremendous risks.
I could have employed a relatively simple strategy that would have been equally as profitable, but considerably reduced my risks had I just done a little extra homework.
I started thinking about this trade over the past weekend when I was looking for another situation that the market appears to be mispricing. The stock is down 35% in just the past few weeks, and option prices seem to me to be “out of whack.”
Once again, they're holding up the "FREE MONEY" sign.
This time, though, I've crafted a trade with far less risk exposure. I'll be sharing this trade with Delta Report subscribers this week.
Best regards and good trading,
Editor, Delta Report
P.S. Ever since that day, I’ve used the technique that saved my fortune to book huge, fast gains for my subscribers. Winners like 139% in 5 days on Target… 150% in 4 days on Toll Brothers… and 400% in one day on Sonic, just to name a few.
To learn more about how you can use my trading techniques to spot short-term, high-upside setups like these, click here.
Today, a reader responds to our recent article: “This Rare Market Anomaly Will Send Bitcoin Even Higher”…
Good article, you note: "At the beginning of 2015, hardly anyone owned bitcoin. The entire market was worth just $4.4 billion. Today, it’s a $113 billion market. That’s 26 times bigger than it was just five years ago."
I would submit the market has not grown at all. Perhaps the number of mined coins has grown a fraction from say 16 million to 16.7 million coins over your time frame mentioned above. There are many more owners today than there were two years ago, but they still own the same coins, the same market. The same 16 million coins are owned, just by a more diverse crowd willing to pay a much higher premium to acquire their coins.
This phenomenon may in fact continue as new buyers must outbid current bitcoin holders to obtain their share of a finite quantity. Maybe we will eventually end up with 21 million people each owning one coin, or 210 million people each owning 1/10th of a coin, or all seven billion of us on the planet owning a fraction of a fraction of a share, who knows?
Regardless, the market remains 21 million coins and at best each coin simply gets more expensive.
And comments on Bill Bonner’s guest essay on the “crack-up boom”:
Great message today. Crack-up boom is no longer an if, but simply a when.
Perhaps I misunderstood your statement, "Of course, everyone believes in the Stimulus Theory just as fervently and unquestioningly as they once believed in the Virgin Birth or Prohibition." If you are implying the Virgin Birth is to no longer be believed you are crossing over a dangerous line that has no relevance to your opinion on the market.
As always, send your comments or questions to us right here.