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The Bear Stearns Mystery: Does Deep Out-of-the-money Options Imply Insider Trading?

One of the big mysteries behind the Bear Stearns collapse was the huge bearish bets being placed right before its collapse. I don't work in the industry or have much knowledge about derivatives but it is interesting for an outside investor observing the situation. The latest speculation seems to be the view that these moves may constitute insider trading. Bloomberg has a good story covering various theories on the big option bets:

On March 11, the day the Federal Reserve attempted to shore up confidence in the credit markets with a $200 billion lending program that for the first time monetized Wall Street's devalued collateral, somebody else decided Bear Stearns Cos. was going to collapse.

In a gambit with such low odds of success that traders question its legitimacy, someone wagered $1.7 million that Bear Stearns shares would suffer an unprecedented decline within days. Options specialists are convinced that the buyer, or buyers, made a concerted effort to drive the fifth-biggest U.S. securities firm out of business and, in the process, reap a profit of more than $270 million.

Whoever placed the bet used so-called put options that gave purchasers the right to sell 5.7 million Bear Stearns shares for $30 each and 165,000 shares for $25 apiece just nine days later, data compiled by Bloomberg show. That was less than half the $62.97 closing price in New York Stock Exchange composite trading on March 11. The buyers were confident the stock would crash.


``That trade amounted to buying a lottery ticket,'' said Michael McCarty, chief options and equity strategist at New York-based brokerage Meridian Equity Partners Inc. ``Would you buy $1.7 million worth of lottery tickets just because you could? No. Neither would a hedge fund manager.''

I have to kind of disagree and actually think that some hedge fund may bet on a lottery ticket. There is so much money sloshing around in the hedge fund world and, like any business, there are many fund managers who don't know what they are doing. Wouldn't one of these "investors" gamble by betting a few million? For even a small fund, a few million is not a lot of money. After all, you are looking at a massive up side (several hundread million) with a small downside (a few million.) The Bloomberg story goes on to highlight further bets in a similar highly speculative vein but even if you add up all of it, it doesn't seem to amount to anything significant.

Olagues, who was an options market maker at the Pacific Exchange and then the CBOE from 1976 to 1984, said he knows all about so-called time decay, implied volatility, arbitrage and the complexities of options trading. The former all-conference pitcher at Tulane University, who started Truth in Options in 2003, said he has found options transactions that convince him Bear Stearns was the victim of insider trading.

``I would stake my reputation on that,'' he said.

Insider trading is quite a powerful charge and it remains to be seen if there is any truth to this speculation.

The reason a lot of the options activity looks suspicious is because of conditions like the following (pay attention to the expirary dates):

``Somebody placed some big bets that day that paid off,'' McCarty said. ``The question is, did they make it pay off?''

On March 14, when Schwartz sought emergency funding, Bear Stearns opened at $54.24 in NYSE trading. That day, the CBOE listed eight new put options that expired in five days with strike prices that ranged from $22.50 to $5. The lowest was 90.7 percent below the opening stock price.

Gail Osten, a spokeswoman for the CBOE, declined to say who placed the order for the options.

``Nobody in their right mind would buy that put unless you knew what was going down,'' said Ray Wollney, Olagues's partner at Truth in Options. On Friday, March 14, a total of 6,303 of the $5 Bear Stearns puts traded.

A lot of derivatives "investors" seem to be speculators but even a speculator would be hard pressed to buy something that expires in 5 days and requires the price to drop 50% to 90%? One could argue that someone may be hedging but on a contract that expires in 5 days?

I always wonder who ends up taking the opposite position in these situations?


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