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Born Again Utilities



By definition any one person's information is never as good as the market's information. In other words, as Kevin Depew wisely inferred in his piece, The Why Axis, there is someone out there who always knows more than you do. This information manifests itself in the stock price (and the pattern of price) before it becomes available to the general public. He also knows that it is fruitless to dwell on the "why;" the why will be apparent soon enough.

This is what drives technical analysis. Even though every situation is a variation of another, there are certain things that distinguish a random pattern from "new" information being incorporated into stock price. I have mentioned before that new information tends to manifest itself in option prices even before the stock price because of the leverage they afford.

An example of this is in the utility stocks. Many of the utilities, just like Enron, got involved in energy trading as deregulation swept over the industry via the Energy Act of 1992 courtesy of "Father" Bush. We all know that story. These utilities became highly leveraged "brokers" of energy, borrowing huge sums to "carry" energy from those with excess energy to those without it. This in effect allowed these companies to control prices by sapping up the excess energy and then "coordinate" with other utilities to drive up the price of energy.

Enron jolted the market into realizing that these companies were no longer the utility companies of old, but highly levered brokers who now underwrote prices of energy. The implied volatilities of the options shot up to unprecedented levels as the stocks gyrated in the wake of the Enron scandal.

Option prices went as far as predicting the demise of several utilities; as an arbiter of these prices, I entered into trades that would be profitable as long as these stock prices didn't go to zero. In doing these trades, which were essentially selling downside puts and buying upside calls and delta hedging with short stock, I was able to create a portfolio of trades that, on a probability basis, had a very good return for risk.

About a month ago, some very large trades occurred that essentially duplicated my trade, but were very large in size and drove the option prices to a point that I not only took off my original strategy, but reversed it, essentially making the opposite bet that the implied volatilities were too low. I started to dig into the fundamentals and found that all these utilities are struggling mightily to return to their original mandate and to de-lever their balances sheets.

So someone's information was better than mine (surprise!). I was originally merely arbitraging option prices, implicitly making the bet that these companies would not go bankrupt. After the unwind of the trade and then reversal, the volatility of these companies has dropped dramatically just as the option prices predicted they would. Lucky for me that this has occurred at much higher stock prices, the only reason why my good trade didn't turn into a bad one.

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No positions in stocks mentioned.

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