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To: jefferson31415

This is the third or fourth article I’ve read about these trades and I have yet to see one written in English. Can you translate it for those of us not into The Market?


3 posted on 09/08/2007 6:48:02 AM PDT by SW6906 (6 things you can't have too much of: sex, money, firewood, horsepower, guns and ammunition.)
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To: SW6906

The basic point of the article is that the buyer of these options in only going to make money if the S&P falls 50% in the next 3 weeks (from 1453 to 700). The question this brings up is why would anyone bet such a thing.

Some terminology...

A ‘Put’ option is the right (but not obligation) to sell a stock/security at a certain price.

Its like a bet...

So if you buy the option to sell something at say 700, the only way that option is going to be valuable is if it is worth less than 700- since then you can buy it on the market for less than 700 (e.g. 600) and then use your option to sell it for 700- making a profit.


7 posted on 09/08/2007 6:56:17 AM PDT by jefferson31415
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To: SW6906; Sender; jefferson31415
''There are 65,000 contracts @ $750.00 for the SPX 700 calls for open interest. That controls 6.5 million shares at $750 = $4.5 Billion. Not a single trade. But quite a bit of $$ on a contract that is 700 points away from current value. No one would buy that deep "in the money" calls. No reason to. So if they were sold looks like someone betting on massive dislocation. Lots of very strange option activity that I haven't seen before.''

======

So sayeth some anonymous ''journalist'', eh?

Before detailing this 'trade' in plain English, let me first say that whoever wrote this A) might have a point and B) explains it so poorly that whatever point he might have gets lost. Second, let me say, he/she might just be a plain garden-variety dingbat.

First, you'll notice that the headline refers to PUT options, yet the paragraph quoted above refers to CALL options. WTF?? A pretty incoherent start to an article.

Second, SPX is a construct product. It doesn't represent shares at all, but the S&P 500 Index. We might say that 1 SPX contract represents 100 ''share-equivalents'' and be accurate, but not 100 ''shares''. The Index itself (so-called ''cash S&P'') is the adjusted sum of the prices of 1 share of each of the stocks in the S&P 500.

Third, and this will require some little preface to explain, the SPX mkt -- or at least the 700-strike options -- is offering a bullish play right now, not a bearish one. I know you folks aren't options traders, so let me lay it out for you.

Here are tonight's relevant prices:

SPX is 1453.55. The SPX 700 calls are 757.10 bid, 759.70 offered (note: this is a very wide bid-offer spread for these options, just be advised). The SPX 700 puts are .05 offered, no bid (note: this is quite reasonable, given that they expire in 2 weeks' time, and would require a 750+ pt drop in the S&P in that time frame in order to become profitable).

Now, if I (or any trader) would buy the 1 SPX contract at tonight's settlement price, and then sell (the usual term is 'write') exactly 1 SPX 700-strike call at the bid (757.10) against my long SPX position, here's the math for my position:

Presumably, 2 weeks from now, the owner of the SPX 700 call that I sold ('wrote') will exercise his option, because (again, presumably) SPX is enormously likely, ceteris paribus to be above 700. These options settle for cash, nothing is delivered or assigned, unlike, say, IBM shares.

My results? Bought 1 SPX at 1453.55. Sold 1 SPX at 700 (courtesy of the call option being exercised -- the buyer of the call option has the absolute right to demand that I sell him SPX at 700), gross result before commissions = -753.55 points. Cash in pocket from selling the SPX 700 call, gross = 757.10 points. Net profit to me = 3.55 points gross.

This P/L statement will be accurate if SPX is ANYWHERE above 700 on 20 September at the close (the options are so-called ''European style'', they can be exercised only on the last trading day, unlike, again, IBM options which can be exercised at any time during their lives, so-called ''American style'').

The logical question here is, why am I not busily doing a whole lot of this trade as described? It's the next thing to free money, right? Well, sort of. I'm not doing this trade because, to do just 1 lot, buy 1 SPX and write 1 700 call, requires on the order of 750 points, $75,000. 750 points to make 3-and-a-fraction points BEFORE commission costs, call it $300 net? How crazy do I have to be, please?

However, there are people like this, who WILL do this trade (pretty entusiastically, too), and this is proven by the fact that -- would you believe? -- 2800 lots of the SPX 700 call traded on Friday. Hey, more power to these guys; I believe I'll just have another beer and watch, thanks.

All right. Now, all we have to do is explain why the open interest in the 700 calls and 700 puts is so high. It is high, too -- 61830 in the 700 call and 116961 in the 700 put -- these are enormous figures for an option strike 700-odd pts away fr/the market. By comparison, the 800 strike -- nearer the market! -- has an OI of just 100 calls and 31211 puts (SP puts almost always have a higher OI than the same strike calls, for strikes below the market...but that's a different topic).

There are two possible reasons that I can see for this situation to exist. First, and far and away most likely, is that some few weeks ago, some major player(s) found an arbitrage play in these options, most likely a 3- or 4-legged play involving one or two other contracts in addition to the 700-strike September SPX. This, for those unfamiliar with arbitrage trading (the location of one or more mispriced assets, and the subsequent trade of other, ''correctly'' priced assets against the mispriced ones), is perfectly common, even day-to-day ordinary in a number of markets.

The second, particularly regarding the calls, in an early unwind. Suppose that some major player(s) had -- in, say, April or May -- put on a position in the October SPX options, and suppose said player(s) have come to be worried about the position, expecting perhaps serious volatility through the rest of September. By executing a trade in the 700 September calls, the player(s) can (it depends on just what their original position is/was, but, trust me here, they'll be able to compute the correct way to do an early unwind) reduce their future risk considerably.

Presumably in this case, the person(s) who buy the options our hypothetical player(s) wrote will exercise them (with the player(s) as a result thus having a short position in the September, the player(s) will exercise their October options, thus acquiring a long position in December SPX (yes, October options are offset into the December contract, but, again, that's another topic), repurchase the short Septembers they received courtesy of option exercise, and sell some other instrument in order to hedge the Decembers and reclaim some (all?) of their cost on the September hedge.

Yes, this is complex. No, don't try this at home. But also, yes, this is exact how a lot of prop desks will manage certain types of trades.

I think the former possibility here is far the more likely.

Now, why don't these huge open interests in the 700 SPX September options forecast a ''bin Laden'' situation (what an asinine term, btw)? Because, if big player A ''knows'' that a replay of 9/11/2001 is on its way, you can bet your sweet ol' grandma that big players B, C, and D do, too.

And the way to profit from such a replay is to buy the puts, NOT write the calls. Why? Writing calls is expensive, very expensive, when they are deep-in-the-money (i.e. when the striking price of the call is way below the current market). Buying deep-in-the-money puts, conversely, is very cheap. Look at tonight's prices again, above. The 700 puts are .05 offered; that's just 5 dollars apiece.

Does it strike you as likely that, if A, B, C, and D -- big players all -- ''knew'' about an upcoming replay of 9/11, that the market-makers at the exchange would **still** be offering the 700 puts for a 'nickel', as we say?

Right you are. As George Bernard Shaw used to say: ''Not bloody likely.''

My net assessment of the article? One, the author needs a thorough course in options, because the text as written demonstrates very clearly that he/she is clueless; two, the author REALLY needs to source his comments, because A) he/she isn't qualifie to make them, and B) there is absolutely no shortage of pros on the exchange floor or at prop trading desks who can and will offer much more coherent commentary, and C) the ''substance'' (sic) of the article, that the action in ONE striking price in the huge SPX options market is a valid harbinger of a replay of 11 September 2001 is an absolute crock.

Good trading to you! (Market tip: don't listen to this putz for your trading ideas! Also...note that the article is unsigned? Hmmmmmnm??)

40 posted on 09/08/2007 9:00:51 AM PDT by SAJ
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