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The high drama at China MediaExpress Holdings (OTCPK:CCME) has carried on this week, with shares nosediving more than 10% Tuesday following this negative SA blog post, followed by a dive and gigantic recovery after Muddy Water's latest report failed to rattle shareholders with CCME closing Wednesday up almost 7%. It appears that the market is unsure what to make of all the allegations against CCME with the stock sitting smack in the middle of the $10-$15 range it has been trading in for the past month.

However, the options market paints a different picture. It suggests that the odds significantly favor the bearish side at CCME. Either CCME is guilty like the bears charge, or CCME call options are wildly underpriced.

Normally the implied volatility (a measure of a stock's anticipated volatility in the future) of a stock's options is roughly the same for call and put positions. Puts sometimes have a slightly higher implied volatility due to the fact that people buy puts to hedge positions more frequently than they buy calls. However, the differential between put and call implied volatility is usually quite small.

However, across all CCME strike prices and dates at present, the implied volatility for puts is far greater than that for calls. In fact, across most strike prices and dates, the implied volatility for puts is more than double that of calls. This means that, practically, one can pick up calls on the cheap while one has to pay an arm and a leg to acquire puts. Why would this be? One reason is that the amount of the float that is short is now so high (more than half the float has been shorted) that it is nearly impossible to find shares to borrow. And rather than covering their bets, short-sellers have been increasingly piling more leverage onto their already large positions.

This is not a sufficient explanation, though, as most hard-to-short stocks don't have the same sort of absurd implied volatility skew that CCME presently has. A little math should clarify this. CCME effectively is in a situation with a binomial outcome. One possibility: The short sellers are wrong, the auditor says everything is okay in March, and the stock goes flying back to the 52-week high as the gigantic short position in CCME has to be covered all at once. The other possibility: The short sellers are right-- the auditor resigns or can't certify the company's yearly filing, past years' reports have to be restated or something of that sort, and the stock dives.

Like a biotech approaching an upcoming FDA decision, there are only two possible outcomes, the good one or the bad one. CCME stock won't still be at $13 in a couple months, either it will be much higher or much lower. For the sake of having numbers to plug in, we'll say a clean set of books pops the stock back to its 52-week high of $23 while a fraudulent set of books sends the stock down to Muddy Waters' target of $3. You can adjust the numbers as you wish without messing up the following math.

In a binomial scenario, you can simply plug in the probability of each outcome and the value if each scenario occurs. For example, a 50/50 chance of fraud or no fraud results in the following equation:

$23(.5)+$3(.5)=Expected Value of $13.

Since there is a 50% chance of getting $23, and a 50% chance of getting $3, on average you will get $13. The stock, presently trading at $13, in this case is fairly priced and you should neither buy nor sell it as the Expected Value of the stock is equal to its current price. If there is a 75% chance of clean books at CCME, then one gets: $23(.75)+$3(.25)=$18. In this case, the expected value exceeds the current price by $5 and so the stock should be bought. If there is a 75% chance of fraud, then one gets: $23(.25)+$3(.75)=$8. In this case, the stock is overvalued and should be sold.

You can adjust the probability and expected outcome of each scenario and determine your opinion of the equity's value using that framework. However, returning to options, one quickly sees something is amiss at CCME. Let's play with the June 2011 $10 call option though any in-the-money call option makes the same point. (I picked June for this example as that gives the call buyer enough time for the market to figure out whether the company is a fraud or not before the call expires. By June, our binomial scenario will have played out.)

One can buy the June 2011 $10 call option for $4.00 (the bid / ask spread is $3.70/$4.10 so $4.00 should get an order filled). Let's see the expected value here. Should the stock go to $3, a $10 call option is obviously worth zero. If the stock goes to $23, the $10 call is so far in the money so as to have no time value and will thus only have intrinsic value of $13. Thus, if the odds of fraud are 50/50, the expected value is: $13(.5)+$0(.5)=$6.50. Not bad considering your purchase price is $4. Every $4 call you purchase has an expected payout of $6.50 even though there is a 50/50 chance of the company being a fraud. That's a 63% expected gain on a coin flip. If you believe there is a 75% chance of the company being legitimate, you get: $13(.75)+$0(.25)=$9.25 value per $4 investment. Each call you buy should make you a more than 100% gain. Good stuff!

On the put side, the June 2011 $16 put option (chosen to be $3 away from the money -- equivalent to the $10 call) goes for $6.40. The put is worth $13 if the stock goes to $3 and is worth zero if the stock goes to $23. Our expected value if the company has a 50/50 chance of being a fraud works out to $13(.5)+$0(.5)=$6.50. So, for a $6.40 investment, your put has an expected payout of $6.50. That is an expected gain of less than 2%. The put is priced correctly, assuming the company has an equal chance of being fraudulent or not, while the call is priced absurdly cheaply. Since being wrong in the options market -- due to high leverage -- tends to wipe a person out, options aren't mispriced all that often.

For the June 2011 $10 call to be priced fairly, the expected value equation would have to work out to something like: $13(.31)+$0(.69)=$4.03=purchase price of $4. That equation would suggest there is a 31% chance of CCME being legitimate and a 69% chance of the company being phony. Of course, the math changes somewhat if you adjust either the $3 or $23 target as outcomes of the binomial event. And of course, there is some small chance that CCME will miraculously continue to trade in the $10-15 range even after its auditor passes judgment on the 2010 annual report. But more likely than not, CCME will either be trading in the $20s or the mid-single digits within the next couple months.

The options market is heavily leaning toward the mid-single digits outcome. While my math is simple stuff you learn in college, the below graphic is from Thinkorswim's sophisticated options software which determines what the options market is forecasting for stocks. The graphic shows the odds of CCME's price being in each price range at each upcoming options expiry based on the current prices of CCME options. You'll see, the prognostication of CCME's future is quite bad: (you can test this yourself by opening Thinkorswim, going to Analyze, and then to Probability Analysis, and then typing in the symbol of your choice)


By June's option expiry, there is only a 9% chance of CCME staying within 10% (11.74-14.34) of its current price, with a 30% chance of the stock trading much north of current levels, and a 62% chance of the stock trading much lower. By January of 2013, there is a nearly 85% chance of CCME trading much lower, with only a 13% chance of it trading much higher. Clearly the options market thinks the CCME bears are probably going to end up being right.

Of course, the options market can be wrong, and these numbers may be skewed to some degree by the fact that it is difficult to find CCME shares to short forcing some bears to buy puts instead of shorting directly. That said, the current volatility skew between puts and calls on CCME is utterly absurd, and should be a bright red flag for CCME shareholders. All warnings aside, if you still wish to be long CCME, you should definitely be buying June or September calls rather than the equity itself. With call options so absurdly cheap in comparison with the potential payoff on CCME, you get an incredibly good return if the company is legitimate from buying in-the-money calls and your downside is limited to your premium.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: China MediaExpress Holdings: Options Market Suggests Future Is Bleak