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Chain Reaction

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Several days ago Standard and Poors downgraded the outlook on the long term debt of R.J. Reynolds (RJR). This obviously affected the price of the company's corporate debt, which in turn triggered activity in credit default swaps (please see past article on credit default swaps). Either existing holders or new buyers of the debt are seeking protection against a possible default. Dealers who are supplying the protection in turn look for protection in equity options.

There has consequently been a flurry of activity in the stock's long term out of the money puts. The implied volatility of the 15 strike options has risen from the mid 40% range to the high 70% range as the buyers seek liquidity. As over-writers (long term holders of stock who periodically sell calls to generate premium) watch the market bid up the option prices, they begin to sell out of the money calls. Enter me. I sell the out of the money puts to the buyers of protection at a 77% implied volatility (and short stock to hedge the delta) and buy the out of the money 40 strike calls from the over-writers at a 44% implied volatility (and again short stock to hedge the delta). This discrepancy in price is how I make my money; the risks associated with the trade must be constantly managed.

A ripple in one market affects all other markets, especially the derivatives market.
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Position in RJR

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