Gaming the Market » Options

Today’s EMC Action

GTM — Wed, 30 Jul 2008 23:05:00 +0000

We at GTM rarely post direct trading info, but this is worth looking at:

Something unusual is going on with EMC. Today gave clever traders an options setup that can be hard to find. It’s where the next strike on the front-month contract, this one being August, is “cheap” and moves 500% in a day. This story aired on today’s Fast Money so the trade is probably done, but it’s something to look for.

Today EMC was approaching $15 and the Calls were less than $1 after it had made nearly a $1 move. Some big institutional money wants EMC over $15. It traded seventeen times its average daily volume, according to Peter Najarian. This is rare for the options market with +100,000 contracts trading just today.

From MarketBeat:

“‘I can’t remember seeing a frenzy like this in a while,’ says Jon Najarian, co-founder of Optionmonster.com, who says that the large size of the trades — 5,000 to 10,000 contracts at once — suggests institutional activity, rather than retail investor speculation. Shares of the stock were lately up 6%.”

Today’s July 30th EMC Aug $15 Calls:

Open at $0.16

Close at $0.66

http://finance.yahoo.com/q/op?s=EMC

Now after Fast Money mentioned it the Bid in after-hours market is $0.89 which is a 550% one day move. Last month the $15 Calls also were the most popular strike with some 30,000 open contracts. Today the $16 Aug Calls opened at $0.05.

According to MarketBeat, “The company is scheduled to present at the Pacific Crest Securities technology conference in Vail, Colo. on August 4. Analysts have surmised that the company might want to spin off its remaining 85% stake in VMWare.”

Say you risk $500 and get 25 contracts at $0.20 and sell them at $1. That’s a 3:1 risk reward, and you walk away with $1,500 profit. [disclaimer: hypothetical idea not trading advice!]

There are strategies to spot these moves. TradeStation has chart based alerts that make this type of setup easier to catch. The basic charting method is to watch the 15min bars. You can see where price broke above the purple line of overhead resistance. Once price made a new three day high it accelerated the move up. With an alert or programmed trade these moves can be caught as they happen. There are lots of charts right now breaking out like this, but the options are $1-$3 per contract, not $0.16!

IVolatility.com has a neat tool. You can decide for yourself what you think the options are really worth.

###

All trades, patterns, charts, systems, etc. discussed and the product materials are for illustrative purposes only and not to be construed as specific advisory recommendations. All ideas and material presented are entirely those of the author and do not necessarily reflect those of the publisher or gamingthemarket.com.

Short Interest Isn’t Full of Shorts

GTM — Fri, 13 Jun 2008 05:49:00 +0000

Ever wonder who the short interest number represents? Turns out some of it is a market neutral strategy. Hedge funds will often short the underlying stock to stay price neutral on the bond, but are not short on the company. The next time you see issues for a Senior Note or a Convertible Bond keep this info in mind. The following is a collection of work from various sources:

How It Works
In the U.S. up to 70% of the issues of convertible bonds are bought by hedge funds.

A long position is taken in the convertible bond and a short position in the underlying stock. In this way they try to exploit the mispricing in convertible bonds. Convertible arbitrage trades currently represent more than half of the secondary market trading in convertible securities with hedge funds as the most important player in this market.

They have a preference for underlying stocks that pay low or no dividends, that are undervalued, liquid and that can be easily be sold short.

Convertibles are bonds which can convert into stock at a certain price at a certain point in the future. Investors get the certainty of bond coupon payments, plus an option to buy stock at a given price if the stock has risen.

The Definition
Convertible Arbitrage involves purchasing a portfolio of convertible securities, generally convertible bonds, and hedging a portion of the equity risk by selling short the underlying common stock. Certain managers may also seek to hedge interest rate exposure under some circumstances. Most managers employ some degree of leverage, ranging from zero to 6:1. The equity hedge ratio may range from 30 to 100 percent. The average grade of bond in a typical portfolio is BB-, with individual ratings ranging from AA to CCC. However, as the default risk of the company is hedged by shorting the underlying common stock, the risk is considerably better than the rating of the unhedged bond indicates.

What It Does
We observe significant increases in the short positions of the underlying stocks after the announcement of a convertible bond issue. In the 30 trading days following the announcement of the issue, the increases in relative short positions for equity-like issuers are about 25 percentage points higher than for debt-like issuers.

When the stock price approaches the conversion price, the delta of a convertible bond increases; since the bond becomes more equity-like (i.e. the price of the bond becomes more sensitive to the changes in the value of the underlying equity). This means that more stocks need to be shorted in order to maintain the neutral hedge ratio, which is defined as a product of the conversion ratio and delta. The opposite holds if the stock price goes down.

However, we do not find evidence that these average declines vary systematically with short-selling activity (i.e., there is no evidence that arbitrage is what is driving the declines).

Moreover, we do not find similar results for the control firms. The cross-sectional results presented in the previous sections indicate that the convertible bond arbitrage strategy has a significant impact on liquidity of the market for the underlying stock.

How Long It Lasts
Callable bonds often have call protection periods, generally greater than six months. The exercise of a conversion option leads to the creation of new shares. Long term strategies will hold the bond for several years while collecting interest.

How It’s Abused (from Felix Salmon)
Let’s say you’re a hedge fund, and you get a phone call from Deutsche Bank asking how much you might pay for a Vivendi Universal convertible bond. You’re more than happy to talk numbers with the guys on Deutsche’s syndicate desk – and then, as soon as you put down the phone, you start shorting Vivendi shares like there’s no tomorrow.

In the case of the Vivendi offering, the share price fell an eye-popping 14% in the three days before issue, so it’s hardly surprising that the regulators investigated. However, even after paying the fines, they’re likely to come out ahead on this deal.

Resources:

Hedge Fund Research, Inc.
http://www.hedgefundresearch.com/pdf/HFR_Strategy_Definitions.pdf

The Convertible Arbitrage Strategy Analyzed
By Igor Loncarski, Jenke ter Horst, Chris Veld
http://arno.uvt.nl/show.cgi?fid=53973

Convertible Bond Arbitrage, Liquidity Externalities, and Stock Prices
By Darwin Choi, Mila Getmansky, Heather Tookes
July 2007
http://www.fdic.gov/bank/analytical/cfr/choi_getmansky_tookes.pdf

Hedge Funds’ Insider Trading in Convertible Bonds
By Felix Salmon
http://www.portfolio.com/views/blogs/market-movers/2007/06/22/hedge-funds-insider-trading-in-convertible-bonds

Do Options Really Move the Stock?

GTM — Wed, 11 Jun 2008 02:45:00 +0000

Hence, we provide evidence that option market activity has a pervasive impact on the price paths of underlying stocks. In particular, the impact is not limited to times very close to option expiration.

Furthermore, the effect is economically significant. The average daily absolute return of the stocks in our sample is 310 basis points and a one standard deviation shock to the gamma of the net option position variable is associated with a 37 basis point change in absolute return. Consequently, we estimate that on the order of 12% (=37/310) of the daily absolute return of optioned stocks can be accounted for by option market participants re-balancing the hedges of their option positions.

Resource:
Does Option Trading Have a Pervasive Impact on Underlying Stock Prices?
Department of Finance, College of Business, University of Illinois at Urbana-Champaign
July 31, 2006