Trading Options on Rumors

Trading options on rumors of buyouts or other meaningful stock activity is a sign that market psychology is getting ahead of market strategy. The business news has recently reported rumors of possible buyouts. Coming on the heels of eBay’s deal to buy GSI commerce for $2.4 billion many options traders are anxious not to miss out on the next great deal. Trading options on rumors is certainly safer than buying stock on rumors as the options trader will only lose the premium paid if and when the rumor is proven false and the stock in question falls in value. In many cases of trading options on rumors the contrarian view wins out and when to buy puts is when everyone else is trading options on rumors by buying calls.

As most rumors don’t turn out to be true we have to ask why it is that trading options on rumors is currently popular. The general consensus is that traders chase rumors when market confidence is high. Successful options traders follow a strict trading strategy based upon analysis of fundamentals and technical market factors. For such a trader the idea of confidence in the actions of unseen deal makers borders on fantasy. This is the greed half of the twin market psychology demons of greed and fear. How to trade stock options successfully entails having a plan, sticking to the plan, and periodically reviewing the plan. The good fairy of back room deal making does not fit into this picture. The saving grace for options traders who chase rumors, again, is that they only lose the premium paid and never have to execute an options contract that they buy.

Certainly there are times when rumors pan out and those who buy options early in the game profit handsomely. A valid way to trade options on rumors is to take a strictly technical approach. The trader watches stock price movement and buys options or exits contracts accordingly. This is the province of the day trader as rumors come and rumors go and stock price changes can be quite fleeting. We certainly see this in what could be called crisis options trading. Events occur around the globe and stock prices can respond out of proportion to the reality of a given situation. Knowing the basics of a stock will help the trader understand the likely limits of trading but in an extremely volatile market it may well be market psychology that drives prices. At such times trading options on rumors can be profitable if the options trader trades the market and not the rumor.

It is because experienced options traders know that betting on rumors is betting with short odds that they tend to buy puts when the market is buying calls or sell calls with expectation that the rumor will be proven false. Experienced traders often demonstrate that how to buy stock options in times of rumor is to buy puts, stay on the sidelines, or raise prices and sell calls.

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