Tuesday, September 29, 2009

CIT Group (CIT) - Gambler shows his hand

Happening right now: As I sit here on the exchange floor, I am keeping a close eye on the 1 strike puts in other months; the exchange floor rumor mill is rife with whispers of more put selling on that line.

CIT Group Inc. is up on rumor that Hedge fund manager John Paulson is considering a potential merger with defunct IndyMac Federal Bank. Apparently the market sees the combination of troubled home loans (IndyMac) and troubled small business commercial loans (CIT) as a good fit. A look at the options markets shows that someone may have had a good idea of what was to come and what the reaction would be.

Peaking at the LevelII quotes from LVP we see:

The Nov 1 puts in CIT had an open interest (OI) of 921 contracts as of the open on Friday 9/25/2009.

On Monday 9/28/2009 the OI spiked to 102,258 (trades occurred Friday); implying someone opened up a 100k contract position. Looking at the Time&Sales Tab on LVP I can see the order(s) was a sale smacking the bid on NYSE ARCA at a dime.

On Tuesday 9/29/2009 the OI jumped yet again to 200,861 (trades occurred Monday); implying another opening 100k contract position (also a sale), this time on AMEX.

Net the position collected $2,000,000 in premium with the risk of getting long 20 million shares for $1.00

Thursday, September 24, 2009

Perot Systems (PER) - SEC says “no cookies for you”

The SEC has charged Reza Saleh, a Perot Systems employee, with insider trading for purchasing over 9,300 calls before the news announcement, spread between two accounts at TD Ameritrade over the last couple weeks. Total profit was over $8 million. Too bad he will never see it!

Monday, September 21, 2009

Perot Systems (PER) – Options order flow leads the way again

It may seem suprising, but when you get hired as a clerk by an options firm, you have a lot of very interesting duties. Clerks spend lots of time running errands, picking up lunch, getting coffee, etc. One of the most interesting “duties” is spending a lot of time playing poker.

Why poker? Because it teaches game theory. Studying betting patterns is a key component of poker. People who bet very heavily are likely to have a good hand, unless they are bluffing. That logic also spills directly over to the options market. A good hand in trading could be superior information. The main difference is in options there is no bluffing. Each trade is real cash being slapped down.

Perot systems is a perfect example. Option volume has been creeping up the last few days, higher than the last two years. Also, IV30 has higher than the last two earnings events.

Looking at the increased option volume, lets look specifically at what happened on Friday. In the Company tab, we can see 900 of the October 20 calls traded on the ask (green color) for .55 two minutes before the close. This is about $50K on this trade alone, betting the stock is going to make a new 2 year high before October expiration.

Monday morning, news hits the wire …

Dell agrees to buy Perot Systems for about $3.9B ($30 cash per share)

To see the terms of the deal, simply click on the “C” (for Corporate Action) icon next the company name in the summary area. A popup appears with the terms of the deal.

Once again, option order flow leads the way and predicts the stock move. Order flow is one of the most important indicators professional traders and market makers use to understand stock movement. That $50K is now worth about $850K.

Thursday, September 17, 2009

CBOE Volatility Index (VIX) –implied volatility, options skew, IV30, IV60 at the Crash of 2008

The VIX is a calculation of the implied volatility of the S&P 500 for a theoretical 30 day option. Everyone knows the VIX is negatively correlated with the SPX, in plain terms, when the market tanks the S&P options become more expensive, and the VIX skyrockets. This relationship is the reason people refer to it as the “fear index”.

There are also options on the VIX. VIX options are fascinating because it’s a set of derivatives on a derivative on a derivative that measures implied volatility of options (another derivative). Here it is:

SPX -> S&P front month options -> VIX -> Vix Futures -> Vix Options

To make things even more interesting, we calculate a theoretical 30 day, 60 day, and 90 day (IV30, IV60, IV90) option for over 3000 underlyings in real time using our live systems, and archive this data historically. So, for the VIX, we have a theoretical 30 day option based on the implied volatilities of the VIX options.

One question we get from our customers all the time is how we calculate the IV30, IV60, and IV90. The simple answer is with brute force. We actually calculate the implied volatility on the bid and ask for each option for each underlying, and we then do a variety of proprietary weighing techniques to help keep the index clean (saving us from things like unusual spreads and other strange market activity). When all else fails, we have to figure it out and do it manually.

Also, we use a method called “forward indexing” that helps us out greatly on issues like cost of carry for things such as dividends, negative interest rates when the underlying is hard to borrow. Forward indexing in this case is basically extracting the implied underlying price from the options prices, since the market makers as a community must have the correct cost of carry to provide a two sided market at all times.

When we added VIX options to our systems, we examined whether our calculation methodology was appropriate for options on futures.

For this test we will be looking at October 27, 2008. This was when VIX was very close to its top, and at the peak of the implied volatility for the VIX options while the market was in freefall. On this day the VIX closed at 80.06, while the S&P closed at 848.92. Nov futures for VIX closed at 59.3 and Dec futures closed at 45. One benefit of having several years of tick data is the ability to extract data for research. I pulled the data for the VIX, VIX futures, and VIX options at exactly 3:45 (15 minutes to the close) on that day to have a peek at what was going on.

The way forward indexing works is finding the strike where difference of the call and put midpoints is the smallest. These strikes are highlighted above. Then take the difference and add it to the strike to solve for the implied underlying. This is basically where the options are saying the underlying is; normally we would use interest for equities, but for this example for futures we will use it as is.

At 3:45 PM EST on October 27, 2008, the actual Nov future is 56.00, and our implied future derived from the Nov option is 55.75. Also, the Dec future is 44.60, and our implied future derived from the Dec options is 44.3. So far, so good!

The next step is to take the new implied future prices, and run those against each month to solve for the implied volatilities. The main quality check everyone needs to be aware of is that put-call-parity is respected and the values that the calls and puts have are approximately the same volatility, especially for the at-the-money options. For Nov, the 55 calls are 146 vol, the puts are 144. For Dec, the 45 calls are 109 vol, the puts are 109 vol. Nice.

Finally, let’s dive into the skew.

The above picture shows the Nov volatility skew for the calls and puts vs. the Dec volatility skew for the calls and puts. Also, there is the IV30 and IV60, which are our proprietary indices calculated on those skews.

The first thing that jumps out at me immediately is the fact that the skew is a frown, not a smile. This is because the VIX is mean-reverting, and mathematically does not use a lognormal distribution. In other words, VIX is somewhat range-bound; it cannot go to 0 and cannot go to 500 (we hope). The traders know this and the bids / offers of the options reflect this.

Second, the IV30 is lower than the Nov options. This is because there are 25 days till Nov expiration. This means 25 days of IV30’s weight comes from November, and 5 days come from December. This drags the IV30 lower. Our conclusion at the end of the test is that the methodology is sound, the calculations line up, and the IV30 and IV60 are solid measurements of implied volatility over time for VIX options.

Overall, the IV30 and IV60 are meant to give a clear unit of measurement for volatility over time. We use this mostly for charting, identifying 52 week high and lows for implied volatility, scanning, alerts and much more in our applications.

Below is a snapshot of the VIX chart with the HV30 vs. IV30 vs. IV60 terms. One interesting thing to look at is how high the HV30 is during this time.

Also, other great resources for the VIX are here:

Vix and more - Ten Things Everyone Should Know About the VIX

Sunday, September 13, 2009

Cadbury (CBY) - Using IV90 to analyze a cash & stock deal

Kraft (KFT) launched cash and stock bid for Cadbury last week for 300 pence (about $5.01) and 0.2589 shares of its stock. Cadbury rejected the offer saying the offer undervalues the company, and also the business models of the two companies do not match. Chairman Roger Carr says that Cadbury is more focused, and Kraft historically has lower growth.

What does this mean for the options?

We need to take a minute and step though the math. Each Cabdury ADR is worth 4 Cadbury shares traded in the UK. With KFT trading $26.10, this puts the bid price approximately $6.60 in KFT * 4 = $26.40 + $5.01 * 4 = $20.04, total of a bid price of $46.44. CBY is currently trading $51.82, about 12% higher than the deal price.

To actually study the options, first go to the options tab, check out the ATM straddle for Oct and Dec. The CBY Oct 50 straddle is 3.50 x 4.75, the CBY Dec 50 straddle is 5.35 x 6.80. Very wide indeed! There is not a lot of volume and open interest in Dec so putting a trade for a good price would be time consuming, is possible.

Next, check the summary area for both CBY and KFT and look at the IV90.

What’s really interesting here is the IV90 of KFT and the IV90 of CBY are about the same. For a $1 move in KFT, this would equal roughly a $1.03 move in CBY. Some very simple math here is that CBY is almost double the price of KFT, which should mean if the deal goes through the options in CBY should roughly be about half the implied volatility of KFT (plus some wiggle room for currency fluctuations).  

KFT currently has an IV90 of 27, CBY has an IV90 of 28. This is implying that all the future drama is worth about 14 volatility points. This is an oversimplified calculation, this does not fly if KFT goes up 25 bucks of course!
The most significant factors that could influence the volatility of CBY would be the following:

1. The board accepts a deal- meaning the long term volatilities should line up.
2. KFT increases the bid with a higher stock percentage, bringing up the volatility the options should trade at.
3. A white knight emerges. The market would probably keep the vols where they are suspecting a bidding war.

Under all scenarios the lack of liquidity is a huge turn off. Wide market mean having to proactively work orders to get the fills you want.  If I were to trade this I would probably want to limit myself to the front months which aren't as wide.

Thursday, September 3, 2009

Sepracor (SEPR) - wow someone has good timing.

Wow, this is really where LVP shines to show you what is going on in the options world. 

So its a nice quiet day in SEPR, nothing special happening... then BOOM out of nowhere the stock rips over 4 bucks from 17.80 to 22.22 in 7 minutes.  Next thing you know, the stock is halted.  News?  Hmm.. nothing that we could find intraday.... But after the close the news was all over ..

Dainippon Sumitomo Pharma to Acquire Sepracor for U.S. $23.00 Per Share in an All-Cash Tender Offer Valued at Approximately U.S. $2.6 Billion

You can see the intraday and the daily chart has a massive spike, the giant green volume bar meaning ISE see's large volume of open customer call buying.  One key point to notice here is the IV30 actually ripped up during this spike, meaning it caught the market makers off guard. 
This is very important, in "ALL CASH" tenders, the vol should be crushed.  If the news was announced before the stock move, the market makers would have lowered the vol to almost nothing like 10-15 vol for the front month options.  One exception to this is if there is the possibility for a higher bid.

Lets look at order flow.  On the company tab, the net deltas and net premium bot and sold, it is showing strong bullish betting almost $600k of premium bot and almost 400K in deltas bot.  Also the largest trade of the day, at 1:09, is an Intermarket Sweep for 925 of the Sep 20 Calls for .10, 7 minutes later, they are $2.20 in the money.  Nice way to turn $10k into $200k in 7 minutes.

Finally, looking at today's IV30, the market makers realize they have been taken to the woodshed on both the stock move and the vol move and as expected they drop the vol 47 points to 12 where we would expect it to be for a cash takeover.