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Alarm Bells: Unusual Options Activity in the Airlines

Howard Simons

Most conspiracy theories aren't worth the vapors they're concocted from; we don't need something elaborate to explain what happens simply in the course of human events.

But options action in two airline stocks ahead of the Sept. 11 terrorist attacks suggests that the very perpetrators of these atrocities may have benefited from the disasters. Unusual action happened in the options of United Airlines' parent UAL (UAL Quote) and American Airlines' parent AMR (AMR Quote), and here's how you can tell.

A New Level of Evil

The most common clues of something amiss in options trading are unusual volume or a jump in volatility or either of these developments occurring in conjunction with confirming price movement in the underlying stock. Options volume alone doesn't tell the whole story, because many options traders and market makers engage in nondirectional "precision" strategies designed to take advantage of unusual volatility differentials between months and strikes , or to arbitrage positions against each other.

Many of these strategies, such as the "box" trades used by floor traders to borrow and lend money, involve large volumes of both put and call options. Other common trading strategies, such as "verticals," involve the simultaneous purchase and sale of call or put options at different strikes. (Visit the Chicago Board Options Exchange's Web site to learn more about the mechanics of these trades.)

Only those obviously directional trades -- large purchases of just puts or just calls without any offsetting spread positions -- really jump out. Not only do these trades indicate something's up, but they often force market makers into buying or selling stock as a hedge. A market maker who sells puts to terrorists is incurring an obligation to buy the stock at that strike price, and is quite likely to sell the stock as a hedge. Let's look at put-option trading in UAL and AMR.

A Suffering Sector

First, it's important to remember that airlines were in trouble before Sept. 11. The 10-member American Stock Exchange Airline Index, or XAL, had already lost 30% of its value since the start of the year. Critical horizontal support had broken, tested from below, and a classic waterfall decline had started to form on the chart. These stocks were not in any shape to withstand the upcoming onslaught.

Amex Airline Index in a Slide Prior to Sept.11

Source: Bloomberg

Next, let's look at the option volumes and volatilities in the three days leading up to and including Monday, Sept. 10. At the time of the attacks, at-the-money strikes for UAL and AMR would have been $35 and $30, respectively, but the questionable activity in UAL took place at the $30 strike. The suspect volumes are highlighted.

Airline Options: Volumes and Volatilities The highlighted options exhibited exceptional volume, and they weren't part of any spreading strategies
	AMR Oct. $30 Strike
	Call Volume	Call Volatility	Put Volume	Put Volatility
9/6/01	10	35.5%	23	35.0%
9/7/01	45	38.4	125	42.7
9/10/01	48	48.5	1535	52.8
	UAL Oct. $30 Strike
9/6/01	NA	36.2%	2000	38.3%
9/7/01	3	35.1	10	41.0
9/10/01	10	37.1	100	42.0
Source: Bloomberg

The highlighted options exhibited exceptional volume, and they clearly were not part of any spreading strategies. I looked in vain at all surrounding months and strikes for anything that could have qualified as the other leg of a legitimate strategy. Only the puts were active, and volatility clearly was skewed toward the put side. Said simply, the trade was a heavy bet that those stocks were headed for a fall. The buyer of the AMR puts on Sept. 10 was willing to pay a substantial volatility premium for the privilege of executing the order.

Option market makers tend to live for such volatility discrepancies. Normally, the high put volatility for the AMR October $30 put would lead to the following trade pair:

1. Sell the overpriced natural put at 52.8%.
2. Sell AMR stock and buy the October $30 call, a combination called a synthetic put, at 48.5%.

That trade didn't happen, and neither did the parallel trade for the UAL options on Sept. 6. This stands as testimony to the normal low volume and illiquidity of these option contracts. Such volume in these options should have set alarm bells clanging immediately.

Similar evidence also exists that the terrorists were shorting aerospace company Boeing (BA Quote), insurers such as AIG (AIG Quote) and Citigroup (C Quote), brokerages such as Merrill Lynch (MER Quote), and hotel companies such as Hilton (HLT Quote) and Starwood (HOT Quote), among others. Overseas insurers like Munich Re also saw unusual trading in their options in Europe.