This morning’s admission from Bear Stearns that it had encountered significant liquidity problems “in the space of 24 hours” and had been granted short-term financing from JP Morgan Chase was designed to bulwark confidence in its market position.
With shares in Bear Stearns down 41% at $33.43 as of this writing, we may safely conclude that the exercise backfired royally – that this morning’s news simply corroborated what the credit-default swaps and option activity had been saying all week long – and that the market is perhaps even affronted, having heard Bear Stearns executives go to such extraordinary lengths to discredit investor concerns throughout the week.
Granted, it’s not necessarily because the Bear Stearns executives were entirely disingenuous in their protestations this week. Precarious exposure to the Carlyle Capital situation, which came to a head yesterday, may have thrown fuel on the fire. For Bear to seize assets from the ailing mortgage fund would have been a worthless move.
We noted earlier in the week that some savvy investors were bending over backwards to buy puts protecting them from a bankruptcy-like event and today those speculators are sitting in clover. Front-month action is playing out heavy at the low-strike calls where open interest has been building exponentially in recent days – the price of the March 25 put at $3.90 has increased 1000% in value overnight, while the price of the 30 put at $6.00 is up 1233% - both continue to attract not just sellers of premium but also buyers, who in the case of the 30 put need to see a decline to $24.00 just to break even on the trade. When open interest began building on these strikes early this week, the delta reading on the puts suggested only about a 2% shot at profitability for either strike, making them a cheap bet on a Bear Stearns meltdown that has paid off handsomely for traders who opted into the wager. Options are now pricing in a better than 1-in-3 chance that Bear Stearns will close below $30.00 by next Thursday.
As this is playing out, we’re also seeing massive volume of more than 11,000 at the March 20 put strike at $2.20 – a position that is currently trading at a 500% implied volatility and being bought heavily. For comparison’s sake, the implied volatility reading on the March 30 put strike is “only” about 400% - which tells us that current demand is greater for the March 20 put than the March 30.
The fact that “only” 1.7 puts are trading for every call in this kind of scenario may be misleading, in that the high price of puts may be leading many traders to profit from the spectacular downside here by selling calls rather than buying puts.
Earlier this week with the shares trading at around $62.50 option market speculators sought to buy puts at the $10.00 strike in July. This piqued our attention given the slimmer than 1% chance at the time that the share price could swoon so low. Investors clearly had their minds focused on the plight of other ailing financial companies and paid a hefty premium for this protection. Over the last month option open interest at this strike snowballed to some 2,000 contracts regardless of the tiny probability of the event coming true. As such, investors paid between $20 and $125 per contract, reserving the right to sell 100 Bear Stearns shares at $10 by expiration. Today those put options have jumped in value to as high as $500. Only 700 lots have trade today, while the likelihood of the event occurring is now predicted by option prices to stand at 6%.
Implied option volatility, which measures the prospects for the underlying share price is trading at extreme levels today amid incredible uncertainty. Naturally, this makes sense given today’s outbreak of bad news as another big name takes a nasty share price hit. Alas, these days no other firm in this arena can hope the spotlight stays off their patch. Unfortunately, the word of the day is contagion.
Rebecca Engmann Darst
