Traders Cooperative

[Joe Stocks]

Some real shenanigans going on in the options and futures markets.
From Jim Brown at OptionInvestor.com. Something you have to read. I wrote Jim about this last week as I saw some of the trades come through. Nobody does their home work like Jim Brown does as he tries to connect the dots. No use checking this stuff out on "snopes" - you can go to the CBOE site and see the open interest on the option charts. Whatever is going on it's nutz! We certainly live in interesting times. Joe


"Have you heard about the Bin Laden Trade? There are currently several billion dollars in option bets that the global indexes will fall 15-35% in the next 24 days. These are not just any option bets or a total of all the puts in the option chain. These are specific bets of a magnitude never seen before. The existence of these bets has prompted chat rooms all over the Internet to label them the "Bin Laden Trade." The challenge is in the quantity and valuation of the trades. Normally somebody buying 10,000 out of the money puts 3-weeks before expiration is either a gambler speculating about a dip or a hedge fund trying to protect long positions. This time of year either of those scenarios are normally valid tactics.

Unfortunately the bets causing consternation on the Internet are much larger and more diverse than just a few thousand out of the money puts. For instance, last week somebody sold short 61,730 SPX 700 calls. Selling calls short has the same result as buying puts but a lot more dangerous. If the market goes down the call value shrinks and you buy them back to cover your shorts at a cheaper price. If the market goes up the value of your calls goes up and you lose money on the trade, sometimes a lot of money. Somebody shorting 61,730 deep in the money calls is taking a monstrous risk but this is not the end of the story.

Those calls are worth $768 per share, $76,800 per contract. Shorting 61,730 contracts produces premium income of $4.74 BILLION dollars. Yes, billion. 61,730 contract times $76,800 per contract equals $4,740,864,000 in premiums. This is not idle chump change and not a frivolous bet. Reportedly this transaction was coded as a spread trade so I went looking for the offsetting entry. Why anyone would want to go that deep in the money for any kind of spread is pure lunacy but stranger things have happened. I found the offset in the SPX 1700 puts where 61,740 contracts were purchased long according to various researchers into the transaction. At today's value of $230 x100 = $23,000 times 61,740 equals $1.42 billion in option premium. Now, if the assumptions are correct the trader has roughly $3.6 billion in premiums sitting in his account and he has a massive short position worth a huge amount of money if the market tanks. How many players are there that can risk $1.5 billion on an option trade?

I tried to analyze this for the last two days and it makes me crazy thinking about it. Assuming the reports are wrong and he went long the calls the numbers are even more hysterical. That would have meant he put out $4.74 billion to bet on the market going higher. If he is long calls then is he short the puts? Shorting the puts raises +$1.42 billion to offset the long calls and has the same effect as being long. Market goes up and your short puts become worth less producing profit when you buy them back.

There is one other option. Suppose some major institution needed some cash really bad and they sold short both the calls and the puts and by doing so they raised $6.16 billion and their risk is actually minimal. Market goes down, calls go down and puts go up by an equal amount because they are so deep in the money. Same in the reverse if the market goes up. No real risk. This would be expensive money since it has to be unwound in 24 days and there will be bid ask spreads and commissions on both sides of 122,000 contracts but it did raise a lot of quick cash for about 4 weeks. If a big firm was in trouble and could not go to the debt markets this would be one way to raise short-term cash. The problem then becomes what if they can't pay it back? Do they repeat it in October options and just roll it forward? Eventually the details will come to light and the market would not like it that somebody was this desperate to raise cash. I view this scenario as only slightly less bearish than the directional trade being discussed in the chat rooms.

So comparing these scenarios, which do you think is most likely? Somebody forked over $3.6 billion to go long the market from 700 points in the money or somebody shorted the market and raised $3.6 billion in cash while doing so? Or did some bank/fund in trouble simply borrow $6 billion from the market for 4-weeks? Remember these are September options that expire in 24 days. No other combination of trade possibilities makes sense when the depth in the money on both sides of the trade is considered. Why go that deep just to be long or short. There is no benefit from being more than 100 points in the money on either side because there is no volatility in the premium 100 points away from the market. You would have to be expecting a very large move. It only makes sense if the trader is short the calls and long the puts as several institutional researchers claim.

If this is a directional trade it is a massive bet on a major market disaster but it gets even more complicated. Somebody, nobody knows who, bought 245,000 September puts on the 2,800 strike on the DJ Eurostoxx 50 on August 16th. This is only material because the index was at 4,100 at the time. That is a very long way from being in the money and it would take a nuclear attack to knock that index back -32% in the next couple of weeks. I don't have a dollar value on that position but I doubt it compares in value to the SPX trade.
http://www.financialnews-us.com/?page=ushome&contentid=2448565379

It gets worse. In the last two days somebody else bought 10,250 puts on the Nikkei 225 Index on the 11,500 strike. The Nikkei is currently at 16,300. Again, those puts were a lot cheaper than the SPX play but still a major bet that disaster will hit the index before their expiration on Sept-14th.
http://www.nippo.ose.or.jp/20070827/html/p_10_03.htm

On Monday CNBC reported that investors have purchased more than $500 million in out of the money put options on the S&P betting we will see a further decline of -5% to -11% before September expiration. Using terms like "doomsday scenario" various analysts feel it is more of a speculation bet than hedging existing positions. This is not normal expiration volume.

On Friday another trader sold 10,000 contracts on each of 12 strikes (120,000 contracts) of deep in the money SPY calls with an average price of $6500 each. That is $780 million in premium received and a huge risk if the market continues higher. The strikes were between $60-$95 with the SPY at $147. Again, very deep in the money calls that nobody would ever do in normal circumstances. Open interest on the strikes before the trade averaged only 265 contracts each. Why so deep in the money unless you expected a very large move?

Mark Hulbert, author of the Hulbert Stock newsletter Sentiment Index (HSNSI), said bearish sentiment is rampant. The HSNSI closed Monday night at 5.5%, which means that on average the majority of stock newsletters Hulbert tracks are recommending investors only retain 5.5% in stocks and 94.5% in cash. Just 10 days ago that number was 11.3% in stocks. The Dow rallied +500 points but the index plunged to near historic lows. Lots of bearishness from the newsletter crowd but those editors are not making billion dollar bets.

There are multiple scenarios making the round as to why anyone with deep pockets would make such a monstrous directional bet. If it is directional and not a cash crunch spread it has to be deep and I mean very deep pockets. The account size and credit worthiness of the trader would have to be unbelievably huge to be able to margin a $5 billion naked option trade where you are going short index calls. The margin would be huge. The trader would have to be credible and have multiple levels of management, including the market maker, approve the trade. Hold that thought. I can just picture that market makers face when he first saw the potential order. Short $4.72 billion in calls? Not on my watch! But it did happen. How much credit does a market maker have to have to cover a trade like that? Sheesh!

Scenario one has the most followers and that is the Bin Laden Trade. People think Al Qaeda will take the seven-year anniversary of 9/11 to hit the US again with another monster attack. 9/11 is on Tuesday again this year as it was in 2001. Rumors have been circulating for months that Al Qaeda was targeting seven US cities for some sort of nuclear attack. (Los Angeles, Las Vegas, New York, Boston, Washington D.C., Houston and Miami. All port cities with the exception of Vegas. Easy to sneak a weapon in by boat.) This is the lunatic fringe but documents captured in the past couple of years have substantiated this plan. Whether Osama can pull it off in my lifetime is doubtful but still a possibility. He did get permission to kill 10 million Americans from his religious leader two years ago. The only way he could do that is with a nuclear weapon(s) or a bacteriological attack. Since 3 known Al Qaeda associates have died from radiation poisoning in the last 3 years, including one in the U.S., I would bet on the nuclear option even if it is only a dirty bomb. You may remember Al Qaeda posted a video on the Internet back in early August showing President Bush standing in a burning White House with the headline "Big surprise coming soon." However, whoever placed that billion-dollar bet would have a tough time collecting if a major terror strike occurred. The SEC and Homeland Defense would have everyone in that trade chain locked up or buried in rubble within days of the event if it appeared to be a prior knowledge trade. Remember, the trader had to be credible to place the trade. Somehow credible with a multibillion dollar account and terror suspect don't seem to fit in the same sentence. However, the 1st Battalion 265 Air Defense Artillery mobilized on Friday under presidential order to deploy to Washington, after a stop at Fort Dix, to provide high tech weapon systems against any potential air threat.

Scenario two has a major financial institution imploding in a very visible way over the next two weeks. If somebody like Bear Stearns or Lehman Brothers were forced to file bankruptcy because of the subprime exposure it would be lights out for the market. That would be a doomsday scenario for the financial sector. Nobody would trust any bank or broker for several quarters to come. The debt wreck from early August would look like a fender bender compared to the global train wreck a major bankruptcy would cause. Since that kind of financial sickness would be hard to contain the odds are good somebody with deep pockets would find out before it was made public. By shorting the indexes with these monster positions they would avoid any specific scrutiny from zealous regulators. "Heck sir, we just thought the market was looking weak and got lucky I guess." It has even been suggested that whichever bank/brokerage is in trouble placed the bet themselves to profit from the beating their stock will take when the truth comes out. Coincidentally BSC and LEH both report earnings on Sept-13th. Is that a clue?

Scenario three has Bernanke and the gang holding fast to the inflation story and not cutting rates on the 18th. Personally I think this would cause another market dip but nothing as potentially dangerous as the first two scenarios. Definitely not enough of a drop to justify $5 billion in risk in one trade.

Scenario four would be a cash strapped bank or fund shorting both sides to raise cash they hope they can pay back in 3-weeks. If they could not pay when those options expire that would be another massive problem for the markets to digest.

Whoever made that trade is looking at something around $1 million in transaction costs not counting any increased premiums from increased volatility surrounding any event. They could easily be looking at $2-$5 million in shrinkage regardless of how the trade turns out. If it was a directional trade and the market goes against them it could easily cost $100 million or so just to exit. Of course what is $100 million when you can afford to wager $5 billion?

I have no clue as to the motive for the trade or even if the facts circulating around the trading desks regarding the trade are true. I can look at an option chain and that open interest still exists on those strikes so somebody is still in the game, somebody with a lot riding on SPX options. Somebody that might just be able to stimulate that crash by a few well-placed program trades to speed things on their way. I look at it this way. This is a perfect chance to follow the money. There is a monster bet on the table and every scenario is bearish to some extent regardless of which one is true. I am going to move my few meager chips to their side of the table on the very good chance they probably know a lot more than we do about future events.