Options: Call Buyer in McGraw-Hill

By Jud Pyle, CFA, chief investment strategist for the Options News Network

Looking at the Jan. 2010 17.5 strike calls in McGraw-Hill ( MHP), we find that they have traded 40,000 times in the first four hours of trading today. The current open interest is a mere 12 contracts, according to the Sidewinder report at www.onn.tv. What is interesting about this call activity is that most of the activity is from buyers of the options.

At first glance, this trade appears very bullish, and it probably is. However, a closer look shows that these options traded with stock, meaning that the call buyer simultaneously sold shares to the option market makers.

The options hit the time and sales at roughly 12:08 EST at a price of $4.75. A look at the time and sales in MHP shares shows that 2.4 million shares traded at $18.25 around the time of the option trade.

The block of 2.4 million is the number of shares that would need to be bought by the option sellers to make this trade delta neutral. So the fact that the investor did a delta neutral trade could mean that he or she is more interested in betting on volatility than direction.

The price of $4.75 in the calls with stock at $18.25 is an implied volatility of 71. The historical volatility for the last three months is 62. So if this investor believes MHP will be more volatile than in the past, then purchasing options on an implied volatility of 71 will make money for the investor if he or she is hedged daily until expiration.

I believe, however, that this trade is still bullish because I think that the investor has sold the stock to the option market makers to control the price jump in the stock caused by the market makers buying the stock in the open market. This way, the investor has managed to only purchase volatility from the market makers rather than delta.

This enables the investor to get a cheaper options price because the option market makers do not have to take stock-price risk at the time of the option sale. This allows the investor to keep the purchase of the stock more anonymous.

The investor may have bought the stock in the market prior to buying the calls. The investor's hope is that the price that is paid for the shares will be less than what would have been implied in the option price if the market makers were left to buy their hedge at the time of selling the calls.

MHP has been a part of the financial crisis because it is the owner of one of the bond rating agencies, Standard & Poor's. Investors are concerned that there could eventually be litigation risk stemming from some of the bond ratings that Standard & Poor's placed on mortgage-backed securities.

The bull case had been that despite the litigation threat, the publishing business was doing well, and without the cloud of litigation, the shares would see an expansion in the P/E multiple.

Unfortunately for the bulls, that story has not played out as the stock has dropped more than 50% since September. As we have seen with other call-buying in this market, this investor might be preparing himself for a potential snap back in the 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."

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