What Looks Too Good To Be True Almost Always Is
Remember, events like stock splits, spinoffs, and other events that re-shuffle the corporate deck also affect options. Here’s an example that illustrates why what looks too good to be true almost always is.
An option is a contract. When you buy or sell one, you enter into
a contract, in the case of Chicago Board Options Exchange (CBOE) options, with the Option Clearing Corporation (OCC). The terms of this contract, such as the underlying, strike price,
expiration date, exercise terms, and so on, are specified and cannot
change except as specified in the contract.
OCC contracts do, however, make the natural allowances for structural
changes in a company (stock splits, etc.), meaning that if you purchase a
call on a company and the company or its stock changes its structure before
expiration, the terms of the call will change to give you a call with
equivalent value on the equivalent entity. For example, if a stock splits
2 for 1, the option on one hundred of the old shares becomes an option on two
hundred of the new shares.
General Motors (GM) recently spun Delphi off into a separate entity, which is trading under
the symbol DPH. Owners of 100 shares of pre-spinoff GM stock received 100
shares of new GM stock and 69 shares of (new) Delphi stock.
 | In general, if you see an opportunity that looks very good, look at it twice, or perhaps even three times. |
that were created before this spinoff were options on the 100 shares of stock in GM as it then was structured. At the time, GM included Delphi, and
therefore the options were on an entity that included Delphi. After the
spinoff, an “old” call option that previously gave its owner the right to buy
100 shares of the old GM stock now gave its owner the right to buy 100 shares
of the new GM stock and 69 shares of the new Delphi stock.
At the time of the spinoff, GM declined about $12 from around 83 to roughly 71, reflecting the value lost
when GM lost Delphi, but the price of the old call options on GM did not
decline, and for good reason: Post-spinoff GM stock no longer contains any
rights to Delphi, but the old calls were calls on stock in the company as it
was structured before the spinoff.
These pre-spinoff GM call options now are calls on both 100 shares of GM
and 69 shares of Delphi. If you sell one of these options and wish to do a
covered write, you have not only to purchase 100 shares of the new GM but also 69
shares of the new Delphi, as this is the package you must deliver if
exercised. If you ignore the spinoff and attempt to cover your write with the purchase of
GM stock only, you will find yourself naked short 69 shares of DPH, which
could create an unpleasant surprise near expiration.
Last Thursday our scans showed one series of GM calls as quite overpriced,
and you may have been tempted to write them against a purchase of GM stock.
GM today is trading around 68 and if you go to the CBOE Web site you will see that
the old June 55 calls (GU FK) are trading around $26 and the old June 60’s (GU
FL) are trading around $21 1/2. You don’t need a computer to see that these
would be great writes if these were calls on GM only.
Our scans are conducted by a computer, which of course does not know
that GM
has spun off Delphi and therefore considered these calls to be priced too high
for the volatility of GM. But if you factor in the cost of Delphi stock,
these are not very interesting writes. DPH is now trading around $19 a share,
so the June 55 call on GM and Delphi has an intrinsic value of $68 + $19 * .69 – $55
= $26+, which is about what they are selling for in the market.
One of our members has been using our most overpriced list to find
interesting writes, and he wrote calls against GM stock only. He told me that
he could not believe his good luck in finding such rich writes. In
general, if you see an opportunity that looks very good, look at it twice, or perhaps even
three times. Our computer scans are just that: computer scans. They are
intended to point you in the right direction, but you still have to do some
homework. Investigate the situations you choose to trade, and make certain
that you thoroughly understand them before you make a trade.
