Stock market averages are holding gains despite a third day of disappointing economic news. NY Empire State Index showed a surprise drop to only 2.3 in June, from 17.1 in May and well below forecasts of 13.5. Industrial Production was off .1% and .2% worse than expectations. Meanwhile, the Univ of Michigan Sentiment Index for mid-June fell to 74.1, from 79.3 and below economist estimates of 77.0. Yet, in an odd way, the equity market seems to find solace in bad economic news lately because it raises the odds that the FOMC will announce additional Quantitative Easing at the end of next meeting on Wednesday. Gains across eurozone equity markets ahead of weekend elections in Greece and amid talk of global Central Bank intervention seemed to help sentiment on Wall Street as well. Trading has been very orderly for Quad Witch options expiration. With less than an hour to trade, the Dow Jones Industrial Average was up 90 points and 10 points from session highs. The Nasdaq gained 30 points. CBOE Volatility Index (.VIX) added .37 to 22.05 amid active expiration-related volumes in the options market. 7.7 million calls and 7.3 million puts so far.
Call buying is a basic 101 options strategy that, on the surface, is easy to understand. Most people recognize that, if you buy a call option, you want the underlying instrument to move up. The amount a call option will increase in value for every point move in the underlying is measured by delta. If the delta of call is .50, it can be expected to increase in value by .50 if the underlying move up 1 point. However, other factors - like changes in implied volatility and time - will also affect an options position. In fact, it is possible that the call option loses value even if the underlying moves higher. Let’s see why using a real world example for recent options order flow.
One week ago, we detected a large buyer of July 40 call options on the iShares Emerging Markets Fund (EEM). Less than an hour before the closing bell last Friday, with shares around $37.90, the investor bought 44,000 July 40 calls on the exchange-traded fund for 51 cents per contract on the AMEX. A source on the floor confirms that calls were bought and open interest numbers Monday indicate that a new position was opened.
July 40 calls on EEM were 5.5% out-of-the-money at the time. The delta was about .25 and therefore if EEM jumped a point, the calls might be expected to increase by about .25% or 50%. That’s the power of leverage. Small percentage moves in the underlying translate into large percentage gains for the options contract. The breakeven of a July 40 call for 51 cents at expiration is $40.51 and equal to the strike price plus the debit paid. The premium is at risk if shares hold below $40 and the position is left open through the expiration (5 weeks). However, the position can be closed out at any time prior to the expiration. The payoff chart shows the risks-rewards of an EEM July 40 call.
Fast forward to today and it appears that the position is being closed, as 43,000 July 40 calls were sold for 54 cents per contract on AMEX. Shares are up to $38.80, or about 2%, on the week but the gain on the calls is only three cents. On 43,000 contracts that’s not exactly chicken feed (unless your chickens like to eat $129K in options profits) but certainly not the gain that might be expected after the underlying moves up 90 cents. What happened?
One, slippage was a factor. The investor paid 51 cents when the market was 50 to 51 cents last week and sold at 54 cents when the market was 53 to 55 cents. Second, time decay hurt the trade. The theta of the contract, which measures the amount of premium lost per day, is .01 – therefore 5 cents of premium was lost due to the passage of time alone. Finally, implied volatility in the contract eased from 27 to 26. Vega measures the amount of premium that an options contract can gain or lose for every point change in the underlying. The vega of the Jul 40 call is about .05. So, the contract lost about a nickel due to the 1-point drop in IV.
Therefore, although the massive block of July 40 calls benefited from an increase in the underlying (delta), it was hurt by falling volatility (vega) and time (theta). The position was probably being closed out today to bank the profit rather than running the risk of holding calls on the emerging markets heading into pivotal Greek elections Sunday.
Safeway (SWY) is off 26 cents to $17.94 and at-the-money June 18 puts on the grocery chain are seeing opening activity today ahead of the expiration. The company scheduled a conference call this morning to address unfounded speculation that it is struggling to obtain short-term financing. Looks like some players were bracing for bad news. 8,450 Jun 18 puts traded on the grocery chain today against 1,102 in open interest. The market is now 10 to 20 cents and the contract is 6 cents in-the-money.
Implied Volatility Mover
VIX is up, down, up and back down this morning (through 11:30 EDT) -- possibly being influenced by the expiration. However, June options on VIX expire next Wednesday. The index is now down .39 to 21.29 after reaching a morning high of 23.90. Noteworthy options trades on the index include a seller of 120,000 June 19 puts, including 82,000 at 7.5 cents. Open interest in the VIX Jun 19 put is 176K and the largest in the product. So, today's put selling might be liquidating trades on the view that VIX isn't likely to settle below 19 next Wednesday.
Unusual Volume Movers
Bullish flow detected in Level 3 Communications (LVLT), with 5,997 calls trading, or 6x the recent average daily call volume in the name.
Bullish flow detected in National Bank of Greece (NBG), with 2,526 calls trading, or 5x the recent average daily call volume in the name.
Bullish flow detected in CenterPoint Energy (CNP) with 3,271 calls trading, or 6x the recent average daily call volume in the name.