option volume settled down Monday after a busy Friday, when the combination of options expiration and the jury decision against the company in the Vioxx case made for some explosive action.
As the news broke Friday, those who had it first were buying thousands of the August 30 straddles to protect against the volatility that was about to set in. A crucial element in the use of
straddles -- option bets that profit from big price movement either up or down -- is that the original news reports were that the jury had reached a verdict, but not what the decision was.
Because of the uncertainty associated with the jury's decision, the initial reaction of traders was panic, and volatility exploded across the board. For example, implied volatility for September went from 36 to 40. Implied volatility, a gauge of the magnitude of a potential stock move, is one of the many factors used in calculating an option's price. (For a list of options definitions, please check out the
glossary for the
Options Alerts newsletter.)
The August 30 puts, which give the owner the right to sell the underlying stock, went from 40 cents to $1 in minutes as traders uncertain of Merck's outlook began purchasing as many puts as they could get their hands on.
Within minutes of hearing a verdict had been reached, traders found out that Merck was found guilty and was to award $253 million to the defendant. The August 30 puts were now in the money as the stock tanked on the announced verdict.
A put option is considered in the money when the strike price is above the market price of the underlying stock. The holders of the puts at that point had a few options. They could have sold them outright for a higher price than what they paid, or exercised them, which would give them the right to sell Merck for $30 a share. They then could have bought the stock back at a lower price. Merck stock may have fallen a little more if not for expiration Friday.
Those who were going to exercise their long put positions over the weekend could have helped stabilize the stock on Friday, as they would have been covering their short stock position they had coming in on Monday. Remember, a put gives someone the right -- but not the obligation -- to sell a specific amount of stock at a specific price at or before expiration. If they exercised the put, they would have been short Merck at $30, so some could have been buying the stock on Friday to cover their short position.
On Monday, we are seeing sellers of volatility as traders had the weekend to digest the news. September volatility has come back in to where it was trading on Friday. There has especially been volatility selling in January 2006. There were sellers of the 40/30 strangle, and 35/25 strangle. The higher strikes in this trade were calls and the lower strikes were puts.
So someone sold the August 40 calls and 30 puts, and sold the August 35 calls and 25 puts in the second trade mentioned. A short strangle is a strategy in which you sell both calls and puts with different strike prices but the same time to expiration. As a seller of this strategy you are not expecting a large move in the stock. You buy insurance (implied volatility) to protect against the unknown, and now the news is known.
There probably will not be any more surprises in the stock, which dipped 0.4% to $27.95 on Monday. I think we will see Merck's implied volatility drift a little lower, especially in the out month, as traders put some sort of value on the stock.
In keeping with TSC's editorial policy, Marino doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.