Monday's Options Report: Harmony Gold, Kinder Morgan, El Paso, American Home Mortgage

Equity markets shrugged off the latest subprime woes, which stemmed from a well-populated conference call at Bear Stearns Friday afternoon during which an executive depicted the blackest picture of the credit markets as he’d seen in many years. That accelerated losses on Friday with financial stocks hit hardest. Over the weekend Bear Stearns has fired one of its chiefs. Although this can’t possibly mark the end of the financial sector’s woes, investors began the week in better spirit as Bear Stearns at least appeared to be dusting the cobwebs off and sprucing up the home.

Elsewhere former Home Depot CEO, Bob Nardelli, who ran that company for seven years, was surprisingly anointed as the new CEO at Chrysler with the ink on the paperwork hardly dry following the Cerberus buyout of the company from the German parent, Daimler AG. Mr. Nardelli negotiated a $210 million retirement from Home Depot, where he quit amid mounting disquiet from shareholders and employees in January of this year. Although the former General Electric executive boosted profits and margins at the home-improvement chain, it came by way of a questionable restructuring of the mix of part-time and full-time employees and a severe loss of ground to smaller competitor, Lowe’s Corporation.

Mr. Nardelli found that Six Sigma operational practices used during his tenure at GE didn’t translate effectively when he moved to Home Depot. Now that Cerberus has stamped its authority on its latest acquisition, the challenge for him now will be to prove that he can stem reliance on low-margin fleet sales, which may ultimately depress the worth of used cars, while at the same time increase Chrysler’s domestic market share.

Later in the week we’ll see whether this kind of spring cleaning has sticking power. On Tuesday credit watchers will seek any clues from the FOMC policy statement to see if Mr. Bernanke and company have any shred of compassion for lenders who failed to foresee the risks of making obligations to less-than-stellar loan applicants. If the Fed throws out the notion that it might yet throw out a safety net, the Wall Street house-party might yet resume. If they fail to comment or simply note that some credit-related decisions have turned out to be questionable, then the party will be confined to the basement.

HMY – South African miner Harmony Gold Mining, is taking another bruising today as CEO, Bernard Swanepoel, unexpectedly and without reasoning announced his resignation. Harmony also posted a trading statement warning that investors’ expectations for the quarter ending in June were too high. Shares slumped 15.9 percent to stand at $11.33 while options trading on volume of 10,390 contracts was seven times the daily average. Implied options volatility jumped by around one-quarter to stand at 51 percent as uncertainty prevailed. At the current price shares are down 31.7 percent since a $16.69 peak within the last three months.

It appears that an investor may have sold 2,350 August calls at the 17.5 strike for a nickel and purchased the September 10 calls for around 1.80 even as shares sank. The higher strike August sale at just 5 cents is the same price as could have been achieved for the 15 calls in August, but means that the share price would need to rally much more to hurt the trader. The September calls are currently in the money meanwhile. On the other hand, decent volume of around 1,000 contracts was evident on the put side at the 7.5 line in both January and February. The premium costs less than a quarter in each case and options traders see a low probability of shares declining that much. One does have to wonder what is behind the disgruntlement at the mining company. One institutional shareholder said that Swanepoel left of his own accord.

KMP – Kinder Morgan Energy Partners has seen its share price drop 5.3 percent in early Monday trading. In doing so, it has undone several months of hard work and shares now stand at $48.21 in comparison to a $57.35 seen in early May. Implied volatility has rarely traded above 17 percent in the last 52-weeks and today’s surge to 45.7 percent is unprecedented. An equivalent of 11 percent of overall open interest is in play in the options arena to start the week. The September 47.5/50 put spread appears to be in action on a 2*1 ratio basis with twice as many lower strike puts trading at a premium of around 2.7 while the 50 puts are trading at 2.40. Since volatility is higher, the call side premiums at prices above the 52.5 strike remain buoyant today.

EP – El Paso Corp - News of an unplanned power outage at its offshore Louisiana facility and general volatility in the commodities sector has heightened speculative interest in options in El Paso Corp, long a popular target for volatility players. Volume thus far today stands at 80,300 contracts, with six times as many puts moving as calls. Particularly heavy traffic has gone through in the September 16 and 17 puts, where volume in excess of 32,000 lots has moved on each of the strikes, on volumes elevated as much as 44 percent. Implied volatility stands at a whopping 50 percent, against 33 percent volatility for these shares historically.

OIH – Oil Service Holders Trust – This morning dip in oil prices below $74 per barrel elicited a 2.6 percent slide in share prices to $162.47, with 80,600 contracts circulating. Puts are outpacing calls by a factor of 1.5, while a look at overall open interest shows twice as many open put as call positions for the ticker. Volatility positioning, deploying puts and calls, abounds in the August series, with the market pricing in 10 percent more volatility for this ETF than it has shown historically.

SPX – S&P 500 index options - In an extremely busy first two hours nearly a half million SPX contracts traded, close to last year’s average daily volume. Obviously few traders feel comfortable taking vacation in what is normally a very slow month. In what has become a common occurrence, the index price retraced itself several times in a $10 range, while VIX easily stayed above the 25 level. Option volume, while still centered in the front month, has begun to spread to the September and October expiration cycles as well. Interestingly, the December 2007 expiry also saw very heavy volume of nearly 50,000 contracts, with two puts trading for every call. A 5000 lot of the ‘Deece’ 1400 puts traded minutes into the session at 51.90, and additional volume in this strike may be part of a 1400-1450 put vertical.

Anatomy of a mortgage crisis – American Home files for Chapter 11 protection

AHM - Fears for the financial health of mortgage lender American Home Mortgages Investment took an unhealthy turn Friday when the company said it was laying off staff and would no longer take mortgage applications. Shares in the company dropped by half to stand at $0.75. As the trading week commenced the company can take no more and announced its bankruptcy filing.

At the end of June the company share price closed at $20.89 but ongoing housing lead fears and concerns over its ability to remain liquid saw shares almost halve in value within three weeks to stand at $10.43. As we look back at the pattern of options trading it never ceases to amaze us how hope springs eternal as call buyers kept trying to pick a bottom for the stock price.

Although there were more than two puts outstanding when compared to each call as of July 19, there was a surprising lack of appetite in chasing the share price lower still. Over the ensuing 11 days during which AHM’s shares drooped by a further 41 percent to $6.46 call open interest gained 13 percent and by 7,763 lots while posturing in bearish put plays only increased by 2 percent or 2,485 contracts.

Of course unless some giddy white-knight comes along and offers to inject some capital into the company, the money spent on call buying will turn out to be a grand old waste of time, since all bets there will expire worthless in the event that the share price fails to revitalize itself. The company has stated that it has been talking to parties interested in its retail and home origination businesses, but no suitor consummated any deal.

However, the same can’t be said of that 2 percent rise in put positioning in this case. For example in the September contract at the 12.5 strike, 1,754 contracts were bought on July 20 at a price of 3.7 or less for a total face value of $648,980. That guarantees the buyer the right to sell shares at or before expiration at $12.50 – even though today shares are trading at just $0.75 cents. Now, to value let’s assume that shares in AHM recover and are trading at $1.00 by September’s expiration. Multiplying the number of contracts by the strike but net of the expected value of the shares at expiration gives a market value for that position of $2,017,100. Taking away the initial outlay still leaves investors with $1,368,120 – but that’s still around a 47 percent return.

A more stunning example of puts in action occurred on July 25 when shares in AHM were trading at $11.13. Investors bought puts reserving the right to sell shares at $10.00 before August’s expiration for a cost of no more than $150 per 100 shares. Transactions totaling 4,590 lots traded that day with a face value of $688,500 contracts. Once again, assuming a $1.00 share price by that expiration date, the value of those positions would stand at $4,131,000 for a 500 percent return.

Of course it’s hard to say whether those buyers held on to these open option positions. It’s hard to look a gift-horse in the mouth. But we mustn’t simply assume that these are all profits for the taking, when these positions may have been hedging or protection against a worst case outcome. If that’s the case you’d have to assume that some real blood was spilled during the share price slide, especially since put volume didn’t accelerate that noticeably as bad news crept out of the woodwork.

VIX – The CBOE Volatility index remained wary of today’s rally and took the longest time to turn red on the session. By noon the index was 1.3 percent lower to stand at 24.83. Call trading remained the dominant theme. In the August contracts a slug of 2,000 puts traded at the 15 strike but that volume paled in comparison to 12,700 calls at the 14 strike, 5,100 calls at the 16 strike and volume of 31,000 and 20,000 lots at the 25 and 30 strikes respectively. The October 20 straddle appeared to be in action 2,000 times at a slightly higher premium cost of 6.65, plotting at a range of between 13.35 and 26.65 by the end of summer.

By 12:00pm the Dow Jones industrial average was 0.64 percent higher at 13,261.30. The S&P 500 index was 0.57 percent firmer at 1,440.85, while the Nasdaq composite index battled earlier declines to rally just 0.07 per cent to 2,512.60.