Money MorningThe Dark Possibility: the “why” here is mootWed Aug 29, 2007 21:10
The Dark Possibility: The fourth and final possibility I see out there is considerably more ominous. In essence, this trade potentially suggests that a very large player has effectively sold his or her SPY holdings for cash, without pressuring the market downward. If this is true, whoever placed this trade is essentially betting that the SPY – and, by extension, the broader market – will lose anywhere from 35% to 55% of its value in the next three weeks. Now – and I stress this – the “why” here is moot to even discuss; we have no idea what their thinking or motivations might be. What is important to understand here is that if this scenario is correct, whoever sold out did so to maximize the value of their SPY holdings, while at the same time avoiding the potential loss in value that such a large block transaction would inevitably cause under normal market operations.
This $900 Million Bet Has Global Traders Talking…
By Keith Fitz-Gerald
Insiders trade when they know something. They’re not supposed to, but they do anyway. It’s just a fact of life.
Most of the time, it’s pretty petty-ante stuff, but occasionally a trade comes along that makes even jaded professionals like me sit up and take notice.
Just such a trade surfaced last Wednesday when anonymous parties agreed to buy and sell 120,000 SPY September call options using deep-in the-money strikes ranging from 60 to 95.
If you’re not options savvy, don’t worry. SPY (AMEX: SPY) – also referred to as a “Spider” in trader parlance – is an exchange-traded fund (ETF) that mimics the performance of the stock market’s closely watched Standard & Poor’s 500 Index (INX). These strike prices equate to a SPY trading between 600 and 950, or roughly 35.81% to 59.46% below where it was Monday.
Any way you cut it, this is a monster trade because it controls 12,000,000 SPY shares. In fact, at a blended price of $7,500 per option, this works out to a $900 million bet that will play out by Sept. 21, when these options expire.
Why haven’t you heard about this on your favorite cable TV money show, or read about it in the business section of your favorite newspaper? Simple: There are just so many possible explanations for this trade that your head would spin. The chances are good that the current lot of reporters just aren’t able to make heads nor tails out of this deal; and with nobody talking, there are simply no warm bodies to interview.
But that hasn’t stopped the professionals in the trading community from trying to figure it all out. In fact, since the trade first came to light about a week ago, the professional trading community I’m a part of has been abuzz with conjecture. That alone makes this a highly unusual trade because – like any small, professional community – we can usually figure out who’s doing what to whom and why – without even having to rely on more than one or two educated guesses. We just know.
But this time around, nobody’s talking.
Naturally, this silence has put the conspiracy theorists on edge and set the blogosphere aflame. Most of the theories are outrageous, but there are a couple that – quite frankly – aren’t so farfetched and even make some sense. But I have to stress, once again, that nobody who’s actually a party to either end of this transaction has been identified or is talking, which makes this all the more noteworthy – and maybe even a little spooky.
So absent the “who,” let’s take a moment and see if we can’t focus on, and figure out, the “why.”
Pushing aside anything that has to do with UFOs, the “third gunman” on the grassy knoll, the Philadelphia Experiment, or the Soviet K-129 submarine’s failed nuclear strike on Pearl Harbor, my experience as a longtime global-capital-markets trader tells me that there are actually some very real and very rational possibilities amidst the wild hypotheses circulating on the Internet. But, they’re just that – possibilities. And even with my admittedly conservative analysis, the scenarios I provide here could be wrong … either completely, or in part. Conversely, there may be an element of truth to one or more of these.
So let’s take a look at several of the possible scenarios that I’ve crafted for you.
* A ‘Dividend Capture’ Strategy: Such a trade could conceivably be part of a monster dividend capture strategy used by several hedge funds and even one of my favorite ETFs, Alpine Dividend Dynamic (Nasdaq: ADVDX). Under this scenario, it’s possible that whoever bought these options will exercise them immediately prior to securities going ex-dividend on Sept. 21, before dumping or selectively rotating out of stocks that don’t immediately take off upon dividends being issued. Such a trader would profit from a rise in the SPY.
* A Major ‘Covered Call’ Play: If this is the scenario, we’re talking about one of the largest covered-call plays in recent memory, if not market history. In contrast to retail investors who commonly use out-of-the-money strategies, many professional traders like me prefer to use deep-in-the-money covered calls that reduce risk and enhance returns at the same time. It’s a volatility play that you won’t read about in any options trading textbook. But it’s also one that doesn’t require a trader to go this deep in the money to pull off, which would make this scenario a bit too strange. [Incidentally, I’ll be talking about this particular trade, as well as some of my other favorite options-trading strategies at the World Money Show in Florida next year].
* A China ‘Dollar Dump’ Play: China hasn’t been stung by the subprime-mortgage mess – or, if it has, it hasn’t reported it, yet. But what if its financial system has been torpedoed by this growing global credit crunch? Well, although China has publicly promised not to, one possible consequence is that the country’s government may be planning to dump dollars in the next few weeks. This would obviously create havoc in the U.S. financial markets, but it would also subsequently give whoever shorted these options the chance to buy them back for pennies on the dollar after a knee-jerk “correction” that creates panic selling sometime over the next three weeks. Assuming China can even collect a mere $5 per option, the victor in this scenario would bank a cool $60 million for their efforts. A $10 profit per option would net $120 million, excluding carry and execution costs … (but with that many zeros, why sweat that “small stuff.”
* The Dark Possibility: The fourth and final possibility I see out there is considerably more ominous. In essence, this trade potentially suggests that a very large player has effectively sold his or her SPY holdings for cash, without pressuring the market downward. If this is true, whoever placed this trade is essentially betting that the SPY – and, by extension, the broader market – will lose anywhere from 35% to 55% of its value in the next three weeks. Now – and I stress this – the “why” here is moot to even discuss; we have no idea what their thinking or motivations might be. What is important to understand here is that if this scenario is correct, whoever sold out did so to maximize the value of their SPY holdings, while at the same time avoiding the potential loss in value that such a large block transaction would inevitably cause under normal market operations.
Stick To The Facts
My advice is that this trade is an important piece of information for investors. Sure you can read the conspiracy theories or plug into the professional traders network, but at the end of the day, all you’ll be left with is still more conjecture.
That’s why I’ll stop short of advancing my own theories as to who made this trade and why.
Instead, I urge you to focus on the facts that we know, which is that somebody traded some very large blocks of options at some very unusual price points a mere three weeks prior to expiration. This means that at least one-half of the traders involved expect something big to happen, and pronto, while the other half hopes that nothing will happen – and feels confident enough to believe that they’re correct.
Interestingly, since I’ve been investigating this admittedly fascinating topic and talking about it at length with my network of professional trading colleagues, there’s been continued trading in the September 60, 65 and 70 strikes, which have added another 6,000 lots of open interest between them in the last few days.
Now for the $64,000 question…
How To Play This Information
There are clearly two courses of action available to individual investors, and each is uniquely dependent on what the investor thinks that this trade suggests.
* Investors who believe this trade suggests an upside opportunity. If you see this big options transaction as a harbinger of higher stock prices, you could effectively cover your SPY trades with one deep-in-the-money SPY call option for every 100 SPY shares you own, and capture the volatility skew this trade exploits on the call side when your SPY shares are called out at expiration. Depending on your basis, you could conceivably use strikes as low as the mystery traders did to achieve that objective.
* Investors who view this as a “preview of coming attractions,” that consists mostly of a sharp sell-off in stocks. If you’re more of a “half-empty” type of thinker, and expect stock prices to fall, you could buy a “grundle” of SPY puts at those same strikes – 90 and lower – for between 0.03 cents and 0.05 cents per lot (at least, that’s where they were trading as I write this). Then, if the market does tank for whatever reason in the next three weeks, you will benefit not only from the fall in price, but also from the resultant explosion in volatility that goes with such an event. The beauty of this trade possibility is that – depending on how far and how fast the market falls – you may not even have to see your puts come into the money to profit if you’re nimble enough. The obvious limitation in this scenario is that the time-value component of each option decays at a very high rate, and is working against you, meaning that the odds are very high that you’ll lose all of the money you use to purchase your put options if nothing ends up happening.
The Bottom Line
The bottom line here is that we may never know who placed the trades. But what we do know is that the trades were placed, and that other investors are apparently piling on for reasons that will only become known in hindsight – if at all.
And this, my friends, makes the trades noteworthy – if for no other reason than they are, like so many things in the global capital markets these days, a complete enigma at the very moment the decisions you must make are at their toughest.
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