What Straddle Pricing Can Tell Us 08-18-2010

Cusick’s Corner
Not much has changed since the Midday, so I will keep this Corner short and sweet. The Claims data that comes out tomorrow morning could add some volatility pre-market, but at this stage it looks like an orderly expiration week. I spent some time looking at straddles today (option strategy with a call and a put at same strike price in the same expiration month). The SPX appears to have the potential to be in a 13-point range, so not a ton of volatility in the short-term is anticipated. You can do this exercise on your favorite index going into tomorrow’s session. See you Midday.

Trading was relatively uneventful on a slow news day. With no economic data on tap, the focus was on earnings. Target (TGT) traded down early after the retailer reported in-line earnings, but then shares turned around after the company made reassuring comments in the post-earnings call. TGT finished up 1.7 percent. Analog Devices (ADI) and Chico’s FAS (CHS) also finished higher on earnings. Deere (DE) and BJ’s Wholesale (BJ) saw post-earnings weakness. Meanwhile, Potash (POT) settled up 3.3 percent on news BHP is taking its takeover offer, announced Tuesday morning, directly to POT shareholders. At the end of the day, the stock news was bullish enough to support a modest 10-point gain for the Dow Jones Industrial Average. The NASDAQ added 6.3.

Bullish Flow
Cree Research (CREE) shares rallied $1.41 to $59.72 and options volume surged, as 32,000 contracts traded on the Durham, NC semiconductor maker. The increasing action was being attributed to takeover chatter. While it’s unsubstantiated, it triggered a bullish reaction in CREE options, as call volume outpaced put volume by a ratio of 3-to-1. August 60 calls, which expire at the end of the week, were the most actives. 5,600 traded. Aug 65, Sep 60, Sep 65, and Sep 70 call options were busy as well.

Bullish flow was also detected in Brocade (BRCD), American Eagle (AEO), and US Steel (X)

Bearish Flow
Best Buy (BBY) shares added 28 cents to $33.18 and bearish trading was seen in December puts on the electronics retailer. The top trades of the day were 345 December 30 puts at the $1.64 asking price and 345 December 25 puts on the 55-cent bid. It looks like a bearish spread was being initiated at a $1.09 net debit. The spread traded more than 3000X on the session and offers its best pay-off if BBY falls to $25 or less by mid-December.

Bearish flow also picked up in NASDAQ OMX Group (NDAQ), LDK Solar (LDK), and Mindspeed (MSPD).

Index Trading
The S&P 500 Index (.SPX) saw heavy trading due to a once per month event related to the expiring of CBOE Volatility Index (.VIX) options. VIX is based on the implied volatility priced into SPX options and VIX options settle on Wednesday. Due to the way VIX options are settled, there is often heavy trading in SPX options, as players buy or sell every out-of-the-money strike in SPX to mimic the exposure to volatility in SPX provided by the expiring VIX contracts. Confused? No worries. Understanding the nuances of the so-called “carpet bomb” in SPX options around VIX expiration is not that important. Just be aware that the heavy trading can cause unusual action in both the VIX and the S&P 500 Index on the Wednesday when VIX options expire. For example, 693K puts and 362K calls traded on the SPX Wednesday, or more than double the recent average daily.

ETF Trading
A massive diagonal spread traded in the PowerShares QQQ (QQQQ) exchange-traded fund Wednesday. Shares, which hold the top 100 non-financial stocks that trade on the NASDAQ Stock Market, finished the day up 18 cents to $45.55. In options trading, the spread involved 150,000 September 45 puts and 150,000 January 41 puts. It traded at 79 cents (per spread) and might be an institution rolling a hedge out an additional three months. That is, they are closing out a bearish position in the September 45 puts and opening a new position in the January 41 puts. The total premium for the spread is $11.85 million.