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Minyan Mailbag - Implied Vols

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. Please note that we share this exchange (from yesterday) with educational intents and do not have an opinion on Martha Stewart (or her stock).

John,

Interested in your thoughts on the implied vols on Martha Stewart (MSO) puts. They look unbelievably expensive in relation to the calls, particularly the in-the-money puts. Any way to play this? The stock cannot be shorted (unless you want to pay a 15% negative rebate)!

We have put in place the following: Buy 100 Sep 40 Calls, Sell 50 Sep 40 Puts, Sell 100 Sep 20 Calls.

Minyan Brian

Brian,

In order to achieve put-call parity in the September 40 puts versus calls, the negative rebate rate would have to be around 30%; in other words, you would have to pay 30% of the stock price per year to borrow and then short the shares.

If a trader could borrow the shares and pay only say 20% negative rebate rate, the trader could then short the stock and then sell the 40 puts and buy the 40 calls (creating synthetic long stock) in order to create a "riskless" trade (there is always some risk like "pin" risk or the risk that the borrow would go bad).

Your trade appears to get around the problem of borrow in that you are only trading options. The short 20 strike calls position acts like short stock as long as the stock stays above $20.

One problem occurs, however, if the trader who is long these 20 calls decides to exercise. You are essentially selling these calls at parity and the borrow of the short stock in all reality is probably extremely difficult to hold onto: the risk of the calls being exercised early is very high. In this case you would have to deliver stock to the call exercise and then scramble to find the shares (scramble means that it might cost you even more than 30%).

Regards,
Prof. Succo

No positions in stocks mentioned.

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