Covered Calls

[m_winston]

Good options trade from Barrons

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New Life for Death Trades
AUGUST 25, 2008

Using options to bet on a company's demise may not be honorable, but it can be profitable.

THERE IS NOTHING SACRED about Fannie Mae (ticker: FNM), Freddie Mac (FRE) or Lehman Brothers (LEH). That investors might wager on their deaths should not cause anyone duress.

These companies and their executives have destroyed too much shareholder value to deserve safe passage through the stock and options market. Still, investors owe them a real debt for they have institutionalized a new type of trading on Wall Street: death trades.

The death trade, circa 2008, mostly entails buying put options and shorting stock, to wager on corporate insolvencies or takeovers at very deep discounts to recent share prices.

The hallmark of the trade is a flurry of activity in puts (options that increase in value when a stock declines) that are far below the recent stock price.

Corporate targets of this trading often contend that rumors are spread with emails and instant messages by nefarious hedge funds who also sell stocks to manipulate options prices and to scare other investors to sell their shares.

Target companies need not die for death trades to be profitable. A lot of money was made trading puts on the wounded Bear Stearns even though the company was ultimately rescued by J.P. Morgan which bought the investment bank for $10 a share.

If death-trade stocks just materially weaken, money can still be made trading in and out of the stock and options. Think of a metronome swinging back and forth.

The tick-tock marks the beat of rumors and frames the trading tempo. A swirl of associated options trading is usually enough to scare stock investors into selling or to viewing stock weakness as an omen.

Options trading is often seen as the purview of the most sophisticated investors, or even corporate insiders, who use options (whose gains magnify those of stocks) to position for bad news. If the stocks do plummet somewhere near zero, the cost of the puts will prove as insignificant as the price of a winning lottery ticket.

Fannie Mae and Freddie Mac are deep in the options market's death pool.

One highly-regarded pension and hedge fund manager recently advised clients that options on these cash-challenged mortgage giants indicate a 45% probability that a government rescue would wipe out shareholders. (See "The End Game Nears For Fannie and Freddie." Monday, August 18, 2008.)

Put options are trading actively that would increase in value if Fannie Mae's and Freddie Mac's stocks fell below $2.50 and $3. The stocks recently traded at about $5, and $2.81, respectively.

Though Lehman's stock is much higher than the mortgage giants' share price, similar sentiments remain on display in the options death pool. On Friday, someone bought put options to bet Lehman's $15 stock could trade as low as $2.50 in October.

Smoke typically reveals fire, but be warned that dalliances with death trades could prompt investigation by federal regulators.

These damaged companies, some of whose stocks have declined more than 90% just this year, have been known to cry that they are victims of rumor mongers working in unholy alliance to inflict mortal harm. The Securities and Exchange Commission usually offers a cuddly shoulder, and a warm hug. It is not clear, though, why regulators do not meaningfully review the very institutions they are charged with regulating to limit the probabilities of these crises from even occurring. But of course, that is a different and more troubling story.

When Bear Stearns first attracted death trades, the Federal Reserve and Securities and Exchange Commission staffers were on site at major banks, including Lehman, to review the corporations' capital positions. This was trotted out by some senior executives like some analgesic that should calm nervous investors. Still, the stocks declined, and the final prognosis seems far from certain.

As macabre as all this might be, death is profitable; it's just that big corporations don't like being on the other side of the trade.

For a time, investors used so-called viatical settlements to bet on deaths of people afflicted with the AIDS virus. That tawdry practice mutated into the so-called life settlements business of buying insurance on healthy, elderly people to prepare for a big payout when they die. At least seven Internet sites exist for betting on the date of death of famous people. Less organized "death pools" exist in offices all over the world. Like betting on who wins the Super Bowl, death pools collect wagers on when well-known people will die. One New York advertising executive wagered on Mother Teresa's death.

If money can be made betting on a Saint's demise, what's so bad about wagering on sinners?

MW