Playing the Scared Masses

The skittishness in shares of banks and brokers has definitely made big bucks for investors betting against the companies lately.  While the credit crisis has locked up the financial system in recent months, LEH, GS and MS managed to report better than expected earnings this week.  When these large cap companies swing up and down 50% in a matter of days, though, company fundamentals are likely taking a back seat.  After Bear Stearns declined 50% last Friday and then another 95% on Monday, anything was on the table, leaving other brokerage companies exposed to worries that they too could easily go under.  In recent weeks, Wall Street has been focusing on the increased options activity in cheap, way out of the money puts.  Traders see this large put volume as a sign that someone is betting on a big collapse in share prices.

Yesterday, Merrill Lynch was under the magnifying glass after rumors of more writedowns surfaced and news reports showed put volume rose significantly.  The stock reacted by falling $5.18 (-11.1%) on the day.  After analyzing the options activity, it shows that it doesn't take too much for a large hedge fund to make a quick buck on this newfound investor anxiety.

Let's say a multi-billion dollar hedge fund decides to heavily short the stock throughout the morning when it's trading relatively flat on the day.  Then they go out and buy a boatload of out of the money puts that are trading at $0.50 to $1.50 (a relatively cheap trade for a very large fund).  Options watchers and financial news outlets see this big put volume and begin to report on it, sending the stock price lower.  By spending a million or so on way out of the money puts (chump change for a big fund), the stock falls $5 on the day and the put option increases significantly in value as well.  The fund would most likely cover the stock and sell the puts by the end of the day, walking away with some hefty gains. 

At the same time, the companies can't really defend their stocks either.  If they come out and say things are OK, and then events change, they will open themselves to litigation.  Another way to defend themsleves would be to announce a buyback.  However, given the cash constraints these companies face, a buyback is out of the question. 

As shown below, yesterday someone did buy a big chunk of April 30 puts at 11 AM for around $1.50.  At that point, the stock was relatively flat on the day at $46.63, so someone could have easily accumulated a large short position throughout the morning.  After the put volume showed up, shares started trading sharply lower.  After a couple of hours, the stock stabilized after dropping 5 points, meaning the fund could have been covering their short and selling the puts.  As long as no one at the fund spread any false rumors about the company, it's a perfectly legal strategy.  We're not naive enough to think that a fund wouldn't call a reporter to talk about the heavy put volume though.  In times like these, you can bet that the smart money is profiting off investor fear.   

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Comments

[Mikael]

If the puts gets solds back at the end of the day to close the position, shouldnt you see a big put volume at the end of the day? for every buyer, there is a seller....

[Justin]

Mikael,

Yes, but we wouldn't expect to see the same sort of spike on the sell side. The selling of the puts would be spread out because there's no need to show a volume spike when someone is exiting this kind of trade.

From the looks of the volume chart, though, it doesn't seem like the buyer of all those puts was able to completely exit the position.

But even if the contract price went to zero, it would only cost the fund a couple of million if they held onto it, and our argument is that the money made on the short position in the stock would trump that.

[eh]

It's the 'better than expected' scam. The more meaningful YoY and QoQ comparisons are lost in all the manufactured hoopla over how earnings met some analyst or other's best guess.