Cisco Options Play Keeps Traders Guessing

Whoever was trading Cisco (CSCO) put options last week sure had people talking.

The massive option buying in Cisco sent shivers through the market, primarily because put-option activity in such size can be interpreted to mean that a major institutional investor -- a hedge fund, brokerage trading desk or mutual fund -- thinks there's more money to be made betting against Cisco than betting on it. Put options, of course, give the holder the right to sell shares at a preset price by the third Friday of the contract's expiration month.

Last Monday, in a single trade on the American Stock Exchange, someone bought 42,000 Cisco September 60 puts. That single position gave the buyer the right to sell 4.2 million (each options contract is worth 100 shares of stock) Cisco shares for 60, about 5 points less than it was trading for at the time, by the third Friday in September.

As word of the put buying filtered out into the mainstream investing community via television reports and Internet message boards, it arguably aided in some of the rough sledding Cisco's shares encountered through the early part of last week. Not helping were investor jitters ahead of the company's earnings report, slated for release after the close Tuesday, Aug. 8.

By Friday, open interest -- the number of contracts in existence -- on the September 60 puts reached about 65,500, the biggest amount of open interest on any Cisco option.

Sell Signal?

What that massive move means for Cisco stock is the subject of some debate, but it has definitely emerged as a factor on a stock that has become one of the most widely held in the world.

"I think this put purchase is hanging over the stock," said Pat Hamilton, managing partner with Letco, the firm that leads Cisco options trading on the Chicago Board Options Exchange, in an interview Friday.

Monday, the stock behaved, closing up 11/16 to 66 1/4 and with no five-digit options activity ahead of Tuesday's earnings announcement.

The difficult part of the equation last week was that options market players couldn't say what the intention -- or the entity -- behind the big put trade was.

Scott Kaye, market analyst and options strategist at Optionetics.com, speculated that perhaps the position was done as a hedge to get past Tuesday's earnings report and possibly the Federal Open Market Committee meeting later this month.

One options trader at a big Wall Street brokerage firm says the heavy put-buying will make Cisco's stock volatile because options specialists and market makers who took the other side of the trade will have to hedge their positions.

Floor traders who sold puts to the big buyers of last week essentially became long Cisco because they are obliged to buy the stock when the options get exercised. To hedge their positions, because they may have to buy the stock if the options are in the money and are exercised, they would from time to time sell stock short, or simply sell the shares outright. (Selling stock short means selling borrowed shares of stock hoping that it can be replaced later at a lower price.)

The options world, though, is populated with many contrarian investors, those who believe strong action in one direction is a sign that a cycle is ending and that the stock will behave in the opposite manner. To them, the heavy put-buying means Cisco could be in for a rally.

Joe Sunderman, an analyst at options firm Schaeffer's Investment Research, pointed out that the put/call open-interest ratio on the front three months options series in Cisco has gone from 0.49 to 0.72 since July 31, an increase that can be directly traced to the September 60 put action.

Looking at the last four earnings announcements, Sunderman says, the equity put/call ratio on Cisco is currently the highest it has been in front of earnings, creating an environment for a bullish reaction to their earnings announcement.

Sunderman points out that market makers will have incentive to ensure September 60 options stay out-of-the-money by their Sept. 15 expiration. Market makers will try to keep the stock above 60 for the next few weeks, he notes.

If the stock slumped back and approached the 60 level, market makers could purchase shares of Cisco in an effort to bolster the stock and keep it above 60, leaving the options they sold to expire worthless.

Conversely, if the stock does fall through 60, there may be a great deal of downside to the stock as hedging pushes the shares lower due to market makers shorting the stock, Sunderman notes.

The investors who bought those puts last week may be making a bearish bet, believing some disaster may befall Cisco's stock, like the recent setbacks for Lucent (LU) or Agilent Technologies (A).

Considering Cisco's strength the past few years and its large following on Wall Street, the big put-buyers' bet against the networking giant's stock may make for a nerve-wracking month.

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