Here we are on the last day of the year, but someone is still hard at work getting a
position ready for the new year. Today, a customer bought 10,000 of the June 42.50 calls for $3.30 and sold 10,000 of the June 32.50 puts for an average price of $2.575.
That means that the customer paid 72.5 cents net to buy the call and sell the put. Open interest at the time was 21 and 30, respectively, for the call and the put. The customer also sold 700,000 shares of stock at $39.
The sale of the stock made the spread what we call "delta neutral," meaning that that was the number of shares that the option market makers would have needed to buy to hedge the spread. A look at the merits of this trade gives us some insights into CERN, as well as its options at this time.
First, let's take a look at why the customer might have sold shares as a part of this trade. One possible reason is that this option trade is a stock-replacement strategy for the investor. That means he is taking shares he had and replacing them with the options. At expiration, the investor needs the stock to be above $43.225 (call strike plus the premium) for the trade to be profitable.
Because the investor sold shares on a 70 delta, that means that they are giving up $2.957 (0.7 times 4.225) for the move in CERN from $39 to $43.225.
Why would an investor do this? Well, for one thing, if the investor is wrong, he does not start to lose at expiration on the downside until $33.225. That cushion might be attractive to the investor. A second reason that the investor might have sold shares is because by selling the option market makers their hedge, the investor does not absorb the market impact of the market makers rushing to buy their hedge.
The market makers are going to be inclined to buy their stock as soon as possible, and because CERN typically trades only 1.2 million shares a day, if the investor had not sold the 700,000 shares at the same time, the cost for the spread may have been much higher.
A look at the difference in implied volatility in the calls and the puts shows us how a bullish investor can take advantage of skew in CERN. Skew is a term that describes the difference in out-of-the-money puts vs. out-of-the-money calls. In this case, the implied volatility of the June 32.50 puts was 54, while the implied volatility of the June 42.50 calls was 43.
So the investor bought volatility on a 43, and sold on a 54. Why do the market makers let the investor do this? Because of supply and demand for options. Typically, market makers have to sell out-of-the-money puts and buy out-of-the-money calls from others. So this investor in CERN is taking advantage of that, and supplying some of the demand.
The last thing to take a look at is the fundamental story behind CERN and how it reminds people of the potential impact that a new presidential administration can have on a stock. CERN started 2008 at $56.40. It bottomed Nov. 20 at $31.58 before rallying back to its current level. Cerner's business is providing health care technology solutions. One of its product lines involves making people's medical records electronic. Could the investor be betting that an initiative by the Obama administration to make records electronic will benefit CERN? Perhaps.
Activity like this does not mean that people should run right out and buy shares of CERN. But it is an interesting case study in how at least one investor is using options to put on a risk profile that is different than just being long shares.
Jud Pyle is the chief investment strategist for Options News Network and the portfolio manager of TheStreet.com Options Alerts. Click here for a free trial for Options Alerts. Mr. Pyle writes regularly about options investing for TheStreet.com.
Jud Pyle, CFA, is the chief investment strategist for Options News Network. Pyle started his career in finance in 1994 as a derivative analyst with SBC Warburg. After four years with Warburg, Pyle joined PEAK6 Investments, L.P., in 1998 as an equity options trader and as chief risk officer. A native of Minneapolis, Pyle received his bachelor's degree in economics and history from Colgate University in 1994. As a trader, Pyle traded on average over 5,000 contracts per day, and over 1.2 million contracts per year. He also built the stock group for all PEAK6 Investments, L.P. hedging, which currently trades on average over 5 million shares per day, and over 1 billion shares per year. Further, from 2004-06, he managed the trading and risk management for PEAK6 Investments L.P.'s lead market-maker operation on the former PCX exchange, which traded more than 10,000 contracts per day. Pyle is the "Mad About Options" resident expert. He is also a regular contributor to "Options Physics."