Investment XYZ

Wednesday, December 06, 2006

Put Option Musical Chair

Today I come to a posting (originally on Yahoo message board) regarding an interesting OVTI put trade:

"Insider Info (1 Rating) 6-Dec-06 12:22 pm Ok kids.... so now after some of you
lost a bunch of money on this stock you will not be surprised when i tell you
how funds take advantage of PMIs (passive minority investors). Want to know what
will be with OVTI in the next 4 weeks ? Shorts are gonna cry this time. Longs
will do good.

What supports this statement?A big fund (can't tell u the
name yet) bought 35000 17.50 for March 2007 puts at the end of last week. They
also have established a huge long stock position on the recent weakness of OVTI
(post announcement). Today, the same fund wrote 35000 30.00 puts for January
2007. Therefore they established so called time spread.I believe that the
smartest ones out there will know what to do with this info :)...."

What's going on with these trades? Is it really anything to do with "bullish" or "bearish" of OVTI, or anything to do with the sophisticate sounding "time-spread"? I doubt, because for such deep in-the-money put (OVTI is $14.17, so this put is $15 in-the-money), one would rather just trading stock rather than trading put. I pull up the current and historical data of OVTI Jan07 30 Put, indeed on 12/5/06, there are 35604 contracts traded. Furthermore, today it has 18004 contracts traded. This is very peculiar -- the open interest of this option is only 8800!

It gets even more interesting: look at the history of this put in past few months, such large trades (10000 to 30000 contracts, representing 1 million to 3 million shares) occurred repeatedly: 12/4/06: 20K; 12/1: 10K; 11/30: 20K; 11/28: 19K; 11/22: 10K;11/21: 30K, 11/20: 20K; 11/14: 10K; 10/18: 12K; 10/17: 38K, etc. While all these huge trades were going on, the open interest stay roughly the same at around 9000! Actually after a huge size trade, the OI stayed exactly the same the next day, indicating the party who bought the put immediately exercised on the same day.

So what's the point of all these trades? One speculates that since the long side exercise right away, it must be done to capture some discrepancy in parity (this put should trade exactly at parity theoretically, since time and volatility is zero at such deep strike). However, if one side can pocket such free money, the other side would lose the same amount in the mean time. Since such a large trade typically is done with two parties who understanding each other's intention very well, it is impossible to expect one party to ask for free money from the counterparty in a straightforward way and do a trade.

The economy of such a trade is quite subtle. It lies in statistics and work in the similar way as call exercise to capture dividends. However in this case it is trying to capture interests, with a pre-determined probability of getting the "free" money, which is different from typical arbitrage, where the free money is captured with certainty until the arbitrage opportunity disappears. Which side of the trade can get such free profit? It is the short side (the side write the puts). Then does the long side become the opposite side to the free profit (thus would incurs immediate loss)? No. the long side of the trade is not the automatic loser otherwise there would not have any trade.

Where does the free profit come from? The magic lies in the open interest of this put. The put, since it is deep in-the-money, should be exercised. Otherwise the put holder is losing the interests he should get. If he exercises, he would end up with short stock position, which should entitle him to short interest rebate. On the other hand, if he continues to hold the put, not only he is not collecting interest payments, he is paying interests to the broker for the cash he used to purchase the put. The fact there is a large open interest in this put indicating there are some put holders who do not understand such money relationship and simply let the free money flow away every day until expiration.

Who would be on the receiving end of free money that the long side of the open interest is losing? Obviously it is the short side. Typically it is the market makers on that end thus the short put positions are hedged 100% by shorting stock. Such hedged position is indifferent to the up and down of stock movements. The "free" money comes in the form of short rebate the short side would receive. If the long side is not hedged, he is equivalent to holding a naked short stock position, thus he is subjected to the daily movements of the stock. It is likely that the interest he would lose appears to be negligible comparing to the stock fluctuations.

So why there are those new trades -- with the long side exercise immediately? Isn't it a total waste of money? It turns out that a rule by Option Clearing Corporation (OCC) in option exercise allows the transfer of free profit from one party to another through the assignment process.

Here is how it works: since option is so-called "fungible", after an option trade is made, two parties of the trade are no longer associated with each other. The trade goes into the pool of existing open positions called "open interest", which has equal number of long and short. When an exercise order comes in, who (among all the holders of short positions) should be get assigned? OCC uses a lottery system to pick the party to be assigned from the pool. Thus if the open interest of an option is 1000 and there is an exercise order for 100 contracts, each short position contract has 1/10 chance being assigned. All in all, such lottery is very fair and effective.

Now back to the trade I am discussing above. The open interest is about 10K, if a 20K contract trade is made, by the end of the day, the long side of the trade will immediately send in the exercise order for the 20K contracts. Now OCC has to randomly pick among 30K (=10K + 20K) contracts of open interest to assign the 20K contracts. Thus the party who was originally collecting free interest money, now has 1/3 chance to be kick out, while the short side of the new trade will have 1/3 of chance to get in and sit in the musical chair to receive free profit.

Here is the whole picture: we have some speculator who is holding 10K OVTI Jan07 30 put. Since OVTI is tanking, his put position is extremely profitable from the stock movement that he forgot (or simply does not understand) to exercise the put and make more money through interests. Now his counter-parties (the short put side but hedged, thus not exposed to stock movement) are all happily collecting interests for free from these 10K contracts that should have been exercised. But wait! Since it is free money, other people who can understand such mathematical relationship and has resource to do it, want a piece of the cake too. So there are all these huge trades happening, trying to get into the action to grab a piece of the free money. The lottery system in option assignment provides a fair opportunity (with a certain probability) for anyone who want to sit in the musical chair.

How big is the potential profit? For each contract of Jan07 30 put, the short side would hedge with 100 shares of short stock, resulting in total $3000 cash (no matter what is the stock price, as long as the stock is well below $30). If the short stock interest rate is 4.5%. For 10K contracts, how much is the interest?

$112,500.00 per month

That is some serious free money. Since OVTI dropped below $20 since July 2006 (thus this put should be exercised at that time and the open interest should be reduced to 0), the total free money (to option expiration in January 2007) for these 10K contracts of sitting position is more than half a million. Obviously that is good reason to get into action for a piece of that. Looking back at the history, the first 20K of such seemingly pointless trade occurred on 9/5/06, when OVTI dropped to 15.45.

How can these trades be made? Considering OVTI is quite a volatile stock, and bid/ask spread on these deep ITM puts are wide, after trading such huge size of options, then put on the hedge, then paying the commission, the cost already wipes out any potential free profit. It seems it doesn't make sense at all.

In reality, such trade are arranged by a broker, with both parties understand exactly why they want to made the trade. The trade will occur at parity with hedging stock trade also complete by both sides. Here is how the economy in this trade: the long side, who is typically the broker (thus the broker not just facilitate the two sides, but likely become one side), would set the price for both the option and stock together exactly like the theoretical value. Thus both sides has no directional risk, and the hedging stock and the option simply pass from one party to another, thus no market risk. After the trade, the long side would exercise immediately. For the entire trade he would just make money on the commissions, nothing else. The short side would lose on the commissions, but trying to get a piece of the half million free money.

Then why doesn't such trade occur in all the deep in-the-money put? The precondition is the puts need to have large open interests standing. Otherwise there is no point of making such a trade.

For regular investors, it is unlikely they can make such trade, due to 1) capital usage; 2) high commission. However it is important for investors to understand the economy and reasons behind such trades, so that they won't make laughable speculation that some fund is bullish or bearish based on these trades. These trades have nothing to do with stock direction at all, neither with 'time spread". It is a purely interest rate and statistical trade (due to the lottery assignment system) that arbitrage on one party who does not understand the mathematics of options fully.

(The author can be contacted at

Web This Site