Massive Mystery Options Play Hints at a Bearish Stock Market End to 2009
Stock-Markets / Stock Index Trading Aug 12, 2009 - 05:49 AM GMTBy: Money_Morning
Keith Fitz-Gerald writes: With the Standard & Poor's 500 Index up 47% from the lows it reached in March, many investors are feeling intense relief.
But with one or more institutional traders making bets that suggest a bearish end to 2009, the question becomes: How do you read this information and what do you do about it?
I'm struck by a sense of déjà vu.
In September 2007, there was a $900 million options wager that became known as the "Bin Laden Mystery Trade." Widely believed to be a massive downside bet on the S&P 500, it was a combination of options totaling 120,000 S&P call options contracts (NYSE: SPY).
Because of its size and the way it was placed, the trade appeared to nervous investors as if somebody, somewhere "knew" something about the S&P 500 being in for a big tumble. Not surprisingly - in this always-anxious, post-9/11 era - speculation about the trade took on a life of its own. In addition to lighting up the chat rooms and conspiracy hotlines, it quickly went mainstream. I recall being asked about it several times on various radio shows and at investing conferences around the world.
I wasn't a popular guy because, instead of playing to the conspiracy theories, I saw another explanation based on 20-plus years of professional investing. As it turns out, I was correct and the trade was some derivation of a "box-spread" options trade.
In case you missed the original article, here's a quick explanation. A box trade is a highly specialized transaction that professional traders or sophisticated institutional investors use on occasion to "box" in the market and guarantee a pre-set level of profits, an acceptable level of risk, or - as may have been the case for that particular trade - it may have been designed to enable an investor (institutional or otherwise) to obtain below-market-rate financing.
This time around, there's a slight wrinkle in that the options seem to be a so-called "put-ratio spread" that expires in December. This transaction calls for an investor to buy a number of "put options," and then to sell more "put options" of the same underlying stock and expiration date, but at a different, lower strike price.
It's a limited-profit, unlimited-risk options strategy that is used when traders think the underlying issue - in this case the SPY - will experience a little volatility in the near future.
According Andrew Wilkinson of Interactive Brokers Group Inc. (Nasdaq: IBKR), an investor last month purchased a "ratio put spread" that expires in August. Wilkinson told Forbes.com that the investor established the bearish trade by using 120,000 "92" strike puts against 240,000 "80" strike puts, a 2:1 ratio established at the equivalent of 920 and 800 on the S&P 500. But as the markets rallied, this investor appears to have closed this trade in favor of a similar strategy involving December contracts.
According to Wilkinson, the trader then moved the long strike up to 95 (the equivalent of 950 on the S&P 500) and sold an additional 240,000 "82" strike puts that would have provided a defense against a market downturn of 14.5% at the time.
Clearly, there is a wide margin for error and a big zone for potential profits if the S&P 500 loses steam. (For reference, the S&P 500 closed yesterday (Tuesday) at 994.35).
In its current form, the options trade appears to have spread out to the point where the ratio spread is no longer clearly visible, or has morphed into an entirely different strategy. But the disproportionately large open interest of 182,157 contracts at 95 and 153,387 contracts at 80 in December seems to suggest that there is still a somewhat sizeable number of traders positioned for a potentially bearish end to 2009.
In addition, based on similarly large and disproportionate open interest in contracts that expire next month, traders seem to have spread their bets out over the third and fourth quarters, which means they're apparently less concerned about the actual timing of any bearish move than they are the actual direction. While they don't mention this in the options textbooks, institutions tend to concentrate their positions in the months coinciding with quarterly earnings reports, since there is more liquidity and depth than in the calendar months.
As of press time, there were concentrations exceeding 100,000 put contracts at the following September strikes: 80, 88, 91 and 95. Any or all of these could be used in conjunction with December contracts to profit if the S&P 500 does drop.
So what does this mean and what can individual investors do about it?
Never one to let the old "X-Files" theme song fade away in my head (okay, I'm a bit of a conspiracy-theorist at heart...), I find it interesting that the initial trade as reported by Wilkinson was 120,000 options contracts. In an era of multi-legged contracts - accounting for hundreds of millions of shares - it's ironic that two disparate trades made nearly two years apart (the "Bin Laden Trade" of 2007 and this latest transaction reported on by Interactive Brokers' Wilkinson) both involve that same number of contracts. Folks tempted to read deeper into the tea leaves than I am may conclude that something sinister is in the works, but at the end of the day I think it's probably nothing more than a coincidence.
As for what this latest trade could mean - well, as was the case with the "Bin Laden Trade," I suspect that there's nothing untoward at play here, either. Therefore, I chalk up the increasingly large positions to savvy traders who understand - as we do - that with the S&P's massive surge since early March, a pullback from current levels is not only likely, but probable.
My view is that it's only logical that traders - the shrewd lot that they are - will want to prepare for that contingency.
If you're of the same opinion and want to play along, there are a number of ways to do so. However, the actual moves you make will depend a lot on your preferences as an investor - as well as your risk tolerance.
For instance, if you're options savvy, you could assemble a put-ratio spread of your own using similar strikes. That way, depending on how far and how fast the S&P 500 falls, you could be sitting on some potentially large windfall gains - while those who didn't prepare for this contingency are forced to conduct financial triage on their investment portfolio.
Of course, if options spreads are not your cup of tea, you could simply buy a handful of cheap SPY put options, and hope the "lottery" pays off: After all, depending on how deep out of the money you go, your chances of winning would be about the same.
But tread lightly. In an era where central bankers around the world continue to play "risk taker of last resort," there are no guarantees that we'll see the "normal" market behavior - the market behavior we would normally expect to see after such a torrid advance in a major bellwether index. Things could just as easily power up in a hurry if the markets - and the investors who comprise those markets - become more confident ... regardless of the reasons why. In cases like that, these bets would turn into losers in a big way and in a big hurry.
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