Fat, drunk, and stupid is no way to go through life, son. --Dean Wormer, Animal House, 1978
I couldn't help but be reminded of that infamous line after reading a bit of less-than-thorough analysis regarding an AOL (AOL) spread mid-morning. Truthfully, nobody in this business of sleuthing option activity of which I'm a part, at times, is perfect. I'll be the first to admit I get it wrong often enough as the market forces participants to work with imperfect information all the time. That said though, I'm willing to call out today's analysis, as my fear is it could lead others into a costly mistake if they take the trade as an absolute with no other options (pardon the pun) available and which are a good deal different.
The trade in question featured a purported long bearish straddle in AOL using the August 33 strike. Decent block size matching prints in the calls and puts of 250 or more contracts and the largest being 1,000 put the tally at near 6,500. Apparently a "spread" designation, according to the analyst detained in our witness protection program, confirms our own spied sleuthing of time stamps and the calls and puts being tied together. To complete the long straddle determination, the prints were noted as having been transacted on the offer side suggesting a buyer of both contracts and thus a quick 1 + 1 = deep in-the-money straddle.
The problem with this conclusion is the assumed position doesn't consider the alternatives, which in our view, offers much stronger evidence of the trade being a conversion. Rather than a very bearish straddle with an extremely expensive long-shot call (factoring in the upside break-even point), the conversion is an arbitrage typically performed by professionals in need of long stock due to their trading activities but not wanting the attached delta. The conversion which is equal parts long stock, a long put and short call allows for this sort of positioning as the options operate as synthetic short stock.
With shares of AOL trading around 27.65, the put maintains a stock-like delta and the call is all but worthless with its quoted "$0.00 bid / $0.10 ask" market. As mentioned, the analyst noted both options going up on the offer. More importantly and not posed to readers, when if ever does a contract go up for $0.00? Correct. "Never!" Thus, already the prints should find us more agreeable to the idea the straddle buyer thesis could be misplaced. This is especially true when the other contract is deep. Let's face it, a few pennies of bouncing between the bid and offer in shares, could make a large difference in that option's parity worth relative to the stock.
Did someone say "parity?" We did, but that's another factor missing from the analyst's straddle assumption. If traders simply look at AOL options, it's quickly obvious deep puts trade above parity while deep calls trade at a discount to their respective put values. What's that mean? Most common and with fairly heavy short interest of 13.6% and short-to-cover ratio of 7 days; it's indicative of a hard-to-borrow situation where those holding short stock might be called in prematurely and face an unwanted delta which needs to be covered. That brings us back, kind of full circle as to why a conversion with its long stock and no delta bias is popular amongst pros active in a stock, particularly ones with difficulty shorting.
What we also saw with AOL's options and which made us question the long straddle was the fact implieds barely moved and remain within their monthly range. That's not exactly compelling confirmation for theorized large scale buyers of premium. Also and as noted, the larger print sizes responsible for the trading activity go hand-in-hand with a non-disruptive strategy like the conversion versus more fantastical "They're buying puts! They know something!" heat-seeking excitement.
Not to be forgotten or to be considered for the first time, today's straddle for $5.70 using matching time prints of $5.60 in the put and $0.10 in the call on today's largest 1,000 lot spread works out to synthetic short stock of 27.50. As the underlying share price at the time was 27.62 - 27.63, that would mean hypothetically the conversion could have been put up for a debit of $0.12 or $0.13. Given the existing short interest stats and those potential real world concerns, that type of pricing is not only not out of question, but, take it from a former market maker (circa 1990 - 2000), certainly approachable to have the luxury of long stock in inventory.
The one missing piece which would otherwise all but confirm our trade thesis is prints in the stock which unequivocally align themselves with those of the options. In fact, the closest size print in shares to the fore-mentioned 1,000 lot was about 90 seconds prior for $27.65. The $0.15 debit differential is in the ballpark based on what's been said. However, the print was for 75,000 rather than 100,000.
At the end of the day -- and quite literally at that, too -- while our information looks to be imperfect, I'd still bet we're much closer to the real truth than not. Maybe a late print after the boys on the NYSE closed up shop for 500,000 at $27.53 on the NASDAQ at 16:10 ET is a piece which helps tie it all together and / or the 18,040 at $27.93 shortly thereafter? It's always possible. Nonetheless, if the spreads turn out to be a long straddle, all we can think is given the much, much less costly alternatives using strangles; we'd like to educate another "whale" sized trader on more sound option methods, regardless of whether they make money down the road or otherwise.
This syndicated article appeared originally at Optionetics on July 12.