SHLD option pricing -- strange?

[ERICOPOLY]

I'm trying to figure this out -- these prices look very strange.

 

Scenario #1 -- buy SHLD stock at $67

1)  Shares remain at $67 you make nothing 

2)  Shares go to $100, you gain 49%

3)  Shares go to $150, you gain 124%

4)  Shares drop to $48, you lose 28.4%

 

Scenario #2 -- write $70 strike 2011 put for $22 and purchase 2011 $100 strike call for $2

1)  Shares remain at $67 you make 34%

2)  Shares go to $100, you gain 40%

3)  Shares go to $150, you gain 140%

4)  Shares drop to $48, you lose NOTHING

 

 

Question A:

Why on earth are people buying the shares when the options route provides more downside and more upside?

 

Question B:

Is this distortion caused by securities lending income that accrues to the buyer of the shares?  And is that why the puts are expensive while the calls are actually rather cheap?

 

Question C:

If you are a shareholder and not lending your shares, why aren't you selling and going the options route?

 

Perhaps the answer is that shareholders don't think it is going above $100, but in that case, isn't it safer from a risk/reward perspective to write the put only (and not buy the call)?  That way you'd be making 45.8% once it hits $70, but be safe on the downside all the way to $48.

 

 

Didn't FFH option market kinda look lopsided like this in 2006 where puts were expensive but calls not?  And that was when securities lending was really attractive for that stock.

[ERICOPOLY]

Another question:

 

How can it be that you can write the 2011 $45 strike put for $8.30 and then buy the $70 strike call for $9.90?????

 

That gives you basically all of the upside potential while taking only downside risk under $45.

 

Once again, securities lending distortion?

 

[oldye]

Agree that it is a similar situation as with FFH in 06, its the synthetic short trade..you sell calls and buy puts

There was a point earlier this year where you could of purchased calls/sold puts and effectively locked in a price of 27$ a share while the market price was 35.  

 

Just looking at the last traded prices on yahoo, you could sell a 2011 65 put for 20.40 and purchase a 65 call for 11.10...synthetic long position with an effective purchase price of 56 w/ exact same risk as buying the common at market.  

[arbitragr]

Yeah it's interesting ... like alot of other stuff you can write puts on the market right now.

 

However you don't have to buy the calls at 100 strike ... well ... not unless you think it's gonna go above 100 (which I don't). That's an unconventional option strategy you got there.

 

So eliminating the calls will get you more of a return.

 

Writing puts take a long time to work out however. The delta is really low.

 

Also ... if SHLD drops below $48 - you lose 100%+ ...

 

Why don't you take a position?  ;)

 

Similar thing to the WFC puts you wrote at 30/2011.  :)

[triedtestedand]

Ericopoly:

 

I've never written a put ... can you help me with how you calculated your percentage gains/losses in the example?  I presume you have to put up some collateral (which for sake of your example looks to be $50) which forms basis for determining the % gain/loss?  It's late ... what am I missing? ;-)

 

 

Scenario #2 -- write $70 strike 2011 put for $22 and purchase 2011 $100 strike call for $2

1)  Shares remain at $67 you make 34%

          -> get $22 on Day 1

          -> give $2 on Day 1

          -> give $3 in 2011

          -> Net $17 in 2011

2)  Shares go to $100, you gain 40%

          -> get $22 on Day 1

          -> give $2 on Day 1

          -> give $0 in 2011

          -> Net $20 in 2011

3)  Shares go to $150, you gain 140%

          -> get $22 on Day 1

          -> give $2 on Day 1

          -> give $0 in 2011

          -> get $50 in 2011

          -> Net $70 in 2011

4)  Shares drop to $48, you lose NOTHING

          -> get $22 on Day 1

          -> give $2 on Day 1

          -> give $22 in 2011

          -> Net -$2 in 2011

 

 

[Uccmal]

Eric, The bet appears to be that Sears is going to go belly up one way or the other. 

 

In addition, You've spotted an irrationality in the market betweent the common and the options market. 

 

A.

[ERICOPOLY]

Also ... if SHLD drops below $48 - you lose 100%+ ...

 

You meant to write 0+%.  You only begin to lose money as it drops below $48, 100% loss doesn't come until stock is at $0.

 

[ERICOPOLY]

I've never written a put ... can you help me with how you calculated your percentage gains/losses in the example? 

 

 

Suppose you don't want to use leverage, then you need to have enough cash to take delivery if the shares get assigned to you.

 

Okay, you write the $70 strike put for $22.  When that settles in a few days you'll have $22 per share in the account.  So if you write 1 contract, that will be $2,200.

 

Because somebody is paying you $22 per share, you are really only risking $48 per share of your own money.  So your maximum return on equity is 45.83% if the shares run "all the way" to $70.

 

And yet you have a natural downside hedge where if it pulls back to $48 you've lost nothing.  Let's say they pull back to $35, which was the March the low - that would bring you a 27% loss.

[ERICOPOLY]

Similar thing to the WFC puts you wrote at 30/2011.  :)

 

The difference is that with WFC you can buy the shares and write the calls for the same return as writing the puts.  But with SHLD if you buy the shares and write the calls you are relatively a big loser compared to writing the puts.  In fact, it would seem really dumb.

 

There is a specific reason why I am better off writing the WFC puts instead of going the share/covered-call route -- I needed to preserve my cash to buy my TIPS.  Otherwise, with WFC I would have been just as well off by writing covered calls.

 

 

This is just weird.  In the first place, if people are so certain that SHLD is going belly up why on earth is the stock up so high?  And why isn't a large shareholder switching out of the shares and drilling the bid on the puts?  

 

Pretty inefficient market -- hope that guy isn't seriously getting the Nobel Prize.

 

Unless... there is a very high yield that shareholders are earning by lending their shares to shorts... in that regard buying the shares might not be so bad, unless you are not lending them.

[benhacker]

Unless... there is a very high yield that shareholders are earning by lending their shares to shorts... in that regard buying the shares might not be so bad, unless you are not  lending them.

 

All good points Eric.  Some comments:

 

1) Borrow on SHLD is tight (meaning, difficult to source over time, the rate is dynamic and sometimes not available)

2) Current borrow is expensive - IBKR quoting me >25% annually.  Has been as high as 70% in the last 8 months.

3) Some folks can't trade options.  Tax deferred accounts often aren't set up here.

4) Some folks have massive deferred tax in their SHLD shares... probably not the best to sell and exploit the options market for those guys.

5) Many investors in SHLD, do not necessary have the ability via their mandate to write puts (ie, most mutual funds).

 

It's an inefficiency.  I own a trivial amount of common in several accounts.  All <100 shares, and all in non-margin accounts.  I own predominantly bonds of various maturities.  I'm probably going to be selling a few puts for myself in a bit though... we'll see.

 

I hope Eddie is lending SHLD treasury shares out to prime brokers.

 

Ben

[Cardboard]

That is a very interesting situation Ericopoly.

 

Actually, the divergence between puts and calls is not just for 2011, but for the entire spectrum of options. Even for October 2009. Puts are on average almost twice as expensive as calls. 

 

For the calls to be much cheaper than the puts, you would need either negative interest rates (not possible) or a sizeable dividend to be paid out (not the case here, at least I can't find it).

 

So normally, this divergence should not exist due to the put-call parity rule and arbitrage. As you pointed out, it is much more advantageous for someone long SHLD to create a synthetic long (buy call, sell put of same maturity and same strike price) than owning the stock. This current divergence should lead to arbitrage or in this case a reverse conversion: create a synthetic long and short the stock. The only rational explanation why it is not happening in this case seems to be extra high lending cost for the shares as Ben pointed out.

 

I am still planning to check on the availability of SHLD shares next week with my broker and on their lending rate. Since I don't have a strong opinion on SHLD either way, implementing a reverse conversion and collecting nearly risk free money sounds great. Although, I suspect that I will be disappointed.

 

It is also probably worthwhile to reinvestigate SHLD. I like Eddie and he has done wonders for me with Autozone around 8 years ago now. Simply buying out of the money calls which are cheap could turn out highly profitable if the shorts lose some interest or if the company just shows some signs of turnaround.

 

Cardboard

[ERICOPOLY]

It is just weird.  2x upside and 1x downside (if you write puts at-the-money and use it to buy calls at-the-money).

 

Leverage is just wonderful as long as your downside isn't levered and your upside leverage comes at zero cost.

 

[bargainman]

So normally, this divergence should not exist due to the put-call parity rule and arbitrage.

 

The only rational explanation why it is not happening in this case seems to be extra high lending cost for the shares as Ben pointed out.

 

Yup that's it. This has actually been going on for quite some time.  SHLD is very difficult to short.  That's why you can't arbitrage this.  I asked a guy who used to be a market maker about it a while ago when I noticed the discrepancy (this was back in April 2009) and he said that that was the case.  "the reason the reversal (buy call, sell put, sell stock) is trading so high is that the stock is very hard to borrow…" 

 

I looked at other stocks that had a high short ratio at the time and noticed that some of them did not have as much of a discrepancy.  He said that it "Will all be based on how hard the stock is to borrow and the probability of getting called in on the short stock."

 

So basically if you're willing to be long the stock and take the downside this is a pretty nice 'inefficiency' to take advantage of.

[BargainValueHunter]

The shorts continue to pour rocket fuel under SHLD...

 

http://finance.yahoo.com/news/Sears-sees-three-way-put-optmonster-2350402919.html?x=0&.v=1

 

A trader sold 8,200 of the January 50 puts for $1.79 against open interest of 12,169. At the same time, they bought 8,200 of the November 67.50 puts for $3.05 and sold 8,250 of the 60 puts for $1.11, according to optionMONSTER's systems. The previous open interest at both November strikes was less than 200 contracts, so this was a new opening put spread.

 

http://www.schaeffersresearch.com/commentary/content/put+volume+swells+on+sears/observations.aspx?click=home&ID=108405

 

Sears Holding Corporation (SHLD - 75.06) saw a surge of put activity on Tuesday, with over 29,000 contracts crossing the tape -- 11 times the stock's average daily put volume. On the other hand, fewer than 2,550 calls changed hands throughout the session.

 

This inclination toward bearish bets is supported by data from the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX). Speculators on these exchanges bought to open 8,976 puts on SHLD yesterday, versus just 282 calls, which gave the shares a single-day put/call volume ratio of 31.83.

 

However, taking a deeper look into Tuesday's options activity, we notice that a long put spread was initiated at the deep out-of-the-money November 67.50 and 60 puts, signifying that shareholders could be hedging their bullish positions against a plunge on the charts. Unlike the typical bearish trader, these protective put buyers are looking for a continued uptrend in SHLD, bracing against a potential near-term downtrend.

 

The equity's 10-day ISE/CBOE/PHLX put/call volume ratio of 3.69 confirms that puts bought to open have more than tripled calls during the past two weeks. This ratio lands one percentage point from a pessimistic peak, indicating that traders on these exchanges have rarely purchased bearish bets over bullish at a faster pace over the past year.

 

Additionally, the equity's Schaeffer's put/call open interest ratio (SOIR) of 2.82 checks in at an annual high. In other words, short-term options traders have never been more bearishly aligned toward SHLD.

 

Short interest climbed 6.1% over the past month, and these pessimistic positions now account for more than 32% of the security's available float. In fact, these bearish bets would take over three weeks to unwind, at SHLD's average pace of trading.