How the Surprise Rate Cut Affects Options

Discussion in 'Wall St. News' started by archon, Aug 22, 2007.

  1. archon


    How the Surprise Rate Cut Affects Options


    LET IT BE SAID THAT BEN Bernanke is a wise man, in addition to being a kind man. For just as it seemed the market was so tough that even a skunk couldn't make a scent, along comes the Federal Reserve with a Friday morning surprise that knocked aside fears that August options expiration would hammer the market even lower.

    While the Fed's decision lit up the tape with broad-based gains, it had a dramatically adverse impact on investors who owned certain Standard & Poor's 500 Index puts.

    What happened is a bit abstruse, but it is important because so many investors, especially big stock managers, use these puts to hedge their portfolios.

    All options expire, of course, but S&P 500 options don't expire at the same time as other options. They expire Thursday night before expiration. The settlement value -- this determines how much the expiring contract is worth -- is based on the opening value of the 500 stocks.

    The Fed's decision to lower rates before the market opened, changed the settlement value. For example, index put options that were in-the-money are now worthless. This means that bearish investors -- depending on the strike prices of their index options -- lost money. "They went to bed dreaming of big profits and woke up to a horror story," said Michael Schwartz, Oppenheimer's chief options strategist.

    Investors who had been preparing for the end of all things financial responded by bidding stock prices way, way, way higher.

    In turn, Jon Najarian, co-founder of, said the Fed's decision wiped out a lot of investors who were betting against the market.

    "He cashed out all the shorts,'' he says. "They're getting killed. He basically took a toaster and threw it in the bathtub with all the bears. There's no second chances; they're dead at this point."

    So even though Bernanke the Benevolent helped to lower implied volatility, it's not clear that anything has really changed. This is a point that will surely continue to be debated in the options market and elsewhere.

    Larry McMillan, of McMillan Analysis Corp., does not believe that the Federal Reserve's decision to lower the discount rate to 5.75% changes anything about the market. "You can't fix everything with just this one little thing," he said.

    McMillan, who was warning of a stock market correction in July, said the intermediate-term is still negative. If the Standard & Poor's 500 fails to hold at 1370 the next time the index declines, he said that "would confirm to us that we're in a bear market rather than just a nasty bull correction."

    If the S&P 500 trades at 1430 or higher, he recommends buying September 139 puts on the S&P 500 SPDR (SPY).

    The Fed's decision sends a big message to the market, and also may increase volatility. Before, the consensus was that the Fed would not do anything to help the market's work off its many excesses that have been exposed by the bursting of the sub-prime mortgage bubble. Now, just a day after a Fed governor indicated otherwise, the Fed has acted. Some investors will now likely suspect that more relief could come.

    The interest-rate sensitive financial stocks, for example, are up sharply on the news, and options traders are positing for further advances, and hedging the gains. Options on the Select Sector Financial SPDR (XLF), which is the sector's proxy, are among the most active in the options market. Bank of America, Citigroup, Goldman Sachs, JP Morgan and Wells Fargo also are trading heavily.

    What is certain, though, is that Bernanke knows a lot more about the market than investors had given him credit for. Prior to this morning, investors questioned if Bernanke, a former college professor, was too much of an academic to run the Federal Reserve. "To make this move on options expiration morning, that's key. It proves he knows a lot more about the markets than most pundits give him credit for," Najarian said.

    Despite Thursday's comeback rally, and Friday's rally on the Fed, McMillan said reviews of stock charts bring words to mind like "disaster, carnage and catastrophe."

    "There is massive overheard resistance on these charts. What creates resistance is when people are just praying for the stock to go to where they bought it, or where they mean to sell it," McMillan said. "And then they sell."

    To be sure, the Fed's decision may have initially delighted investors, but it may not do anything to ease the volatility of the market.