A Bullish Bet With Tell-Tale Signs of “Smart Money”

Hey Traders,

Usually, when it comes to trading, I prefer to keep it domestic …

(À la Capitol Gains, where Frank and Andrew play the biggest news out of DC by finding the trades everyone else overlooks!)

Especially with the drama that seems to always be plaguing Chinese tickers these days …

Misreporting, government crackdowns … does it ever end?!

I mean … look at Alibaba (Ticker: BABA) …

Once an online retail powerhouse …

Now, not exactly my top choice for my portfolio …

But … after a bullish note from Morgan Stanley, a different Chinese stock caught the eye of a number of deep pocket traders.

Here’s how they played it.

If Chinese stocks at large have been having a rough go, tutoring and educational names such as TAL Education Group (Ticker: TAL) and New Oriental Education & Technology Group (Ticker: EDU) have had it extra hard, faced with an onslaught of new government regulations such as mandates that educational and tutoring institutions must go non-profit and cannot IPO or take foreign capital; that Chinese students cannot take curriculum-focused classes during weekends and vacations, on top of the general ‘tech stock crackdown’ rules.

Naturally, these new regulations did not bode well for Chinese tutoring stocks, and EDU’s bad year kept getting worse and worse …

Chart courtesy StockCharts

However, EDU may have clear skies ahead, after enjoying sector tailwinds on hopes that the barrage of Chinese government regulations may finally be coming to an end …

In addition, EDU has pivoted to accommodate these new regulations by offering “non-curriculum” based courses, such as coding, chess, and outdoor education, as well as offering adult-education programs in fields such as time management and language training.

If you can’t beat ‘em … circumvent ‘em, right?

EDU shares jumped on the news last week, and their clever workaround didn’t go unnoticed by U.S. analyst Morgan Stanley, who issued an upgrade to the shares on Monday, valuing the stock at $3.50 per share (although cautioning that growth may take some time to become apparent).

Chart courtesy StockCharts

Although the new price target is still quite a ways away from the $18 EDU was trading at earlier this year …

At this point, EDU investors will take what they can get!

And in the options pits, it seems some Big Money traders are betting some of this upside will appear sooner than Morgan Stanley thinks …

Or they are at least nervous that it could appear!

After Monday’s announcement, EDU’s trading volume hit four times its normal amount, with 138,000 call contracts and 59,000 put contracts crossing the tape.

Sentiment in EDU’s pits is certainly skewing bullish for a beleaguered Chinese tech name …

With 1.6 calls currently opened for each put on the board.

One trader in particular can be credited with a not-insignificant amount of these contracts …

Shortly before the market closed for the day, this trader opened up a risk reversal ratio spread, selling-to-open 50,000 October 2-strike puts at an average price of $0.255.

At the same time, they bought to open 37,500 contracts of the October 2.5-strike calls for $0.34.

By selling a greater number of puts, they were able to use their $1,275,000 premium received from the put sales to actually break even on their more expensive call contracts!

What is a risk reversal?

A risk reversal position looks similar to a synthetic stock position – but with a few distinct advantages, such as greater leverage – and is typically is used to hedge an existing short or long position at a lower cost (in this case, the purchase of the calls was entirely covered by the sale of the put contracts, and would serve as a hedge to a current short position) or to double-down on an existing directional play.

The purpose of a risk reversal position is to reverse volatility skew by selling the higher volatility option and purchasing the lower volatility option – since puts typically have a higher implied volatility (and are typically more expensive) than calls.

The trader is trying to capture upside in EDU without putting out the full capital required to purchase the shares outright, and there is significant profit potential should EDU surge higher. 

Additionally, if EDU side winds and expires between $2 and $2.50, this trader simply walks away without sustaining significant losses.

However, the downside risk is substantial. Should EDU fall to $0 (unlikely, but hey, not impossible), their maximum loss would be realized, and the trader could be on the hook for a whopping $10 million.

Here is the risk chart:

Risk reversal plays in equity markets are often used by institutional investors, and the sheer magnitude of this trade would also indicate this to be the case.

And it wasn’t the only sizable bet crossing the tape in EDU’s pits …

In three separate trades (though likely made by the same trader) we saw huge volume on the September 3-strike calls: 13,004 contracts purchased for $0.15, 12,985 contracts purchased for $0.14, and an additional 12,943 contracts bought for $0.10!

If we go ahead and assume that it was all the same trader, that’s $506,280 on fairly out-of-the-money calls set to expire in just over two and a half weeks!

Of course, if these bets (especially the risk reversal play) are actually hedging short positions, they may not be quite as bullish as they seem on the surface …

But at the very least, it would mean EDU shorts are getting worried …

Or there’s multiple traders out there feeling optimistic that the Chinese company will be enjoying some upside in the weeks to come! 

Regardless, I might think twice before going against these Smart Money moves, and opening an outright bearish bet on EDU right now …

Of course, like I said, I’m staying away from Chinese tech stocks right now anyway …

And opting for more “patriotic” wins with Capitol Gains!

Our DC insider Frank Gregory knows how the wheels of Washington work …

And Andrew Giovinazzi uses his 30+ years of trading experience to make the best plays on the hottest up-and-coming news stories.

Membership is open …

But it won’t be for long, so make a move now if you’re interested …

Your Only Option,

Mark Sebastian

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