Options Update: Are Short Sellers Buying Calls to Cover their Financials Positions?
When news first broke that the Securities & Exchange Commission (SEC) was banning short selling on several financial institutions, my gut reaction was that today’s Intraday Volume Explosion List would be jam packed with put activity on companies such as Washington Mutual
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PowerRating), Morgan Stanley
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PowerRating), and Goldman Sachs
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PowerRating).
With short selling removed from the equation, I fully expected investors and market makers alike to dive into put options in order to replace their short positions so that they would remain hedged in the current market environment.
I was aware that the obvious drawback to this would be the cost of effectively renewing those hedges, as implied volatility was sure to spike as a result of the SEC’s actions (not that it wasn’t already historically high given the extreme volatility in the market during the past several weeks). Therefore, I wasn’t prepared for the deluge of financial-related call volume that is sweeping the Street this afternoon.
The chart above is today’s listing of most-active options, filtered to show only financial-related stocks and exchange-traded funds (ETF). Notice that General Electric
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PowerRating) — which I covered in yesterday’s edition of Options Update — and the Select Sector SPDR Financials ETF are the only financials making an appearance in the put-volume chart.
Meanwhile, investors are loading up on Citigroup
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PowerRating), Bank of America
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PowerRating), Morgan Stanley, and Washington Mutual calls. The question is, “Why?” The answer is most likely hedging, but not in the form that I initially expected.
While I assumed that short sellers would need to cover their positions following the SEC decision, I expected those shorts to simply buy back the shares on the open market, and then place the corresponding put to replace the hedge. While this method could be effective, it is cumbersome, and there is a much better way for short sellers to exit their positions: buying calls. It may not seem intuitive at first, but buying calls on shorted shares enables a trader to effectively cap their losses.
Take Citigroup for example. Let’s say that one of the traders who shorted the shares in May — when the stock was rejected by overhead resistance in the 28 region — was concerned that most of his profits on the position would evaporate due to today’s sharp rally in the market. Specifically, a break above round-number resistance at the 20 level could signal that the stock is poised for an even sharper move higher. So, the trader purchases a September 20 call with the expectation that he will be assigned the shares at $20 following expiration.
In this way, even if the stock surges to 25 or above late in the session, the trader is limited to paying only $20 per share for C, thus limiting his losses and covering the short position at the same time.
Looking at weekly charts of BAC, MS, and WM, we can see that the most active call options on these stocks are home to formerly key support for the equities. By buying calls at these strikes, short sellers can easily cover their short positions while ensuring that they don’t pay too much to exit their bearish trades.
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Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.