Killed by the Huntsman

Jun.20.08 | About: Huntsman Corporation (HUN)

Shares of Huntsman Corp. (NYSE:HUN) fell by over 40% yesterday as markets digested the news that buyout firm Apollo Management and one of its businesses, Hexion Specialty Chemicals Inc., announced after the market close yesterday that they were suing to back out of an agreement to acquire the chemical maker for $6.5 billion. To quote from a BUSINESS WIRE press release of June 18th:

Hexion said in the suit that it believes that the capital structure agreed to by Huntsman and Hexion for the combined company is no longer viable because of Huntsman's increased net debt and its lower than expected earnings.

Well, some astute options traders were all over this play even before the news hit the wires. Significant options activity was seen in several at-the-money and near-the-money strikes. The July 17.5 puts traded nearly 6,800 contracts and the July 22.5 calls traded over 5,000 contracts. And all of this volume was due to investors and traders establishing new positions, as reflected by this morning’s updated open interest figures.

Open interest is the measure of option contracts that remain as positions for buyers and sellers. Every new buyer, that also has a new seller on the other side, adds 1 contract to the open interest total. We know that these were new positions because Thursday’s starting open interest almost exactly reflects an increase due to the volume of contracts traded yesterday. The July 22.5 call open interest nearly doubled on Wednesday, by roughly the amount of contracts traded, to end the day at 10,857. And the July 17.5 puts open interest increased to 27,418, over 6,000 contracts higher than the previous day, due again to the new trading positions.

I spoke with experienced option market makers in Chicago about the unusually high volume in these strikes and they told me they didn’t know anymore than I did—but wished that they did! Navigating the uncertainty, many suspected that “someone knew something” and may have been taking these positions in advance of rumors or speculation that some bad news for HUN would be forthcoming.

How much did these put buyers and call sellers profit? Looking at the puts alone, we can gage by yesterday’s close of $1.00 that buyers made over 450% profits, with those puts trading this afternoon at $5.50. And the sellers of those July 22.5 calls are probably going to keep the $1.37 or so they collected in premium yesterday, since the options are now trading for about 10 cents. It is also quite likely that some investors and traders bought both of these contracts as a common option combination trade known as a “strangle.”

A strangle involves the simultaneous purchase of both an out-of-the-money call and an out-of-the-money put and benefits when the underlying security moves sufficiently in either direction. So, for anyone who paid about $2.37 for the 17.5 put/22.5 call strangle, betting on a big move either way, he or she realized a profit as soon as HUN stock moved enough to make one of the options worth more than that $2.37 premium paid. In yesterday’s case, the calls became essentially worthless, but the puts exploded in value and created over 100% returns for the buyers of this put and call combination, known as the strangle. The sellers of this strangle are obviously feeling the pain today of being on the wrong side of this trade.

If these returns don’t stoke your interest in the power and leverage of options, consider Bloomberg’s headline on the topic: “Huntsman Buyout Concern Spurs 10,100% Rally in Bearish Options.” Their story by Michael Patterson and Jeff Kearns yesterday highlights option activity in the June expiration; specifically the 17.5 strike puts which “jumped to $5.10 from their 5-cent close yesterday.” Volume there yesterday was only 300 contracts versus open interest of 600, so that tells me there were not too many big bettors in the June contract yesterday with the contract set to expire tomorrow. In any case, while many stock investors planning on this M&A deal to be completed were “killed by the Huntsman” (lyrics from a Tool song), a lot of options traders made out like bandits. Hopefully for some of the long-stock folks, they were in the options too for a hedge.