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'Smart' Money is Called That for a Reason

April 25, 2007

Dear Fellow Options Trader,

When you're tracking action in the stock market, it pays to know what "smart money" vs. dumb money.

The difference is that the smart money isn't taking random shots and hoping to score big in the options markets; instead, these big-money investors are spending big bucks to buy options either because they've been tipped off about a stock's prospects, or they calculate that the odds of profiting from a particular trade are significantly in their favor.

One recent example of mega-money players making big bets, but with different timing, happened in MedImmune (MEDI), and my examination shows dumb money being burned and smart money ringing the register. Here's how that story played out.

MedImmune, which is the maker of nasal vaccine FluMist, was trading in a tight range of $30 to $34 from October 2006 through February 2007. The volume picked up dramatically when Carl Icahn got involved with MEDI, which tends to happen when his name becomes associated with a company's stock. In fact, on Feb. 15, Icahn's ownership of 2.8 million shares sparked a 6% surge in shares of MEDI, pushing them up to $33.

Mr. Icahn's involvement in MEDI also caused the Street to take buyout rumors about the FluMist manufacturer much more seriously. The volumes of call options trading in MEDI spiked from 2,900 per day in January to upward of 6,100 per day in February.

But keep in mind that Icahn's ownership stake -- then valued at some $92 million -- had less than 10 trading sessions' worth of impact on the trading of calls and puts in MEDI. A better gauge would be March, where my computers show MEDI calls averaging 12,000 contracts trading hands per day, more than triple their January average.

Much of that March speculation didn't pay off for investors betting on a takeover in the short term, as shares still languished at the $35 level. But for as many broken dreams as there might have been when March expiration came around, the buyers of April options had to be pulling their hair out, as those options expired worthless on Friday (April 20).

Why? Because on Monday (April 23), the news about a takeover by AstraZeneca (AZN) would have made those investors a small fortune! Talk about bad timing, some unlucky souls might have lost on both the March and April expirations! I often pound the table about the fact that you've got to buy enough time for your trades to work out, and those who were hoping to make a quick buck by betting on a deal happening sooner rather than later (if one even happened at all) might have been too disgruntled to make another bet (i.e., in the May options), which could have paid off rather handsomely!

However, the smart money is always the better tell, and during the first 14 trading days of April, the smart money hit faster and more furiously than any previous money.

Specifically, our proprietary HeatSeeker program showed massive call speculation that pushed MEDI's average daily call volumes above 45,000 contracts per day! Most of that surge of speculative buying of calls came after the company appointed Goldman Sachs (GS) to explore the sale of the company. It retained GS on April 12, and shares of MEDI traded up 11% that day to just shy of $42.

Then, with the smell of blood in the water, the takeover paper came in big (i.e., institutional-sized) waves. The buying peak hit on Wednesday, April 18, when the stock traded up to $46.70 on a 34 million-share turnover and 102,000 calls changed hands. Upward of 70,000 calls traded that Thursday and almost 50,000 changed hands Friday. Those buyers were richly rewarded, as news of AstraZeneca's $58-per-share cash bid moved calls with a strike price of $55 (or slightly higher) in-the-money.

Speculation was highest in the MEDI May 50 Calls, where the open interest had built to 50,458 contracts, or more than 5 million shares of stock. The next most heavily accumulated options were the MEDI May 47.50 Calls, where 28,685 contracts were open, representing 2.8 million shares of stock.

The MEDI May 47.50 Calls jumped in value by $6.80 and the MEDI May 50 Calls exploded higher by $5.85, representing gains of 290% and 620%, respectively. A quick check of the math associated with those two strikes showed that some $48 million in profits were made by the smart money that accelerated their buying in the sessions preceding the announcement of the AZN takeover.

According to published reports, much of the call-buying and put-selling in MEDI came from none other than hedge fund giant Steve Cohen and SAC Capital. As my friend Roddy Boyd wrote in the New York Post: "SAC's Cohen and his traders have increasingly found it lucrative to buy shares in companies that are the target of Icahn's agitation for change. Real estate developer WCI Communities, Time Warner and video-game developer Take-Two Interactive Software are the most prominent examples."

What my friend forgot to mention was that Mr. Icahn is also a newly announced significant holder in Motorola (MOT), but that might just be a story for another day, and you can say you heard it here first!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader