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Building a Position


On August 25 I wrote a piece called "Options and Dividends" where I used R.J. Reynolds(RJR:NYSE) options to illustrate the effect dividends have on option prices. Since then there has been a great deal of activity in the options of 2006 where a possible dividend cut will greatly affect these prices. This recent activity, however, is motivated not by a possible change in dividend policy, but by credit.

There have been large buyers of the January 10 and 15 strike puts of 2006. These buyers are not speculating that the company will drop through these strikes; they are using them as a hedge against default risk as they are buying the debt at the same time. The debt was recently downgraded based on the company's lower cash flow. Because they are buying the debt with leverage (they are hedge funds), they must ensure (even if they believe that there is very little chance of default) in some way that the value cannot go to zero.

I have described this trade before. They are paying very high prices in relative volatility terms (to the other options) because these strikes match their risk profile: they are hedging tail risk, the low probability of a substantial drop in the stock price (which would normally, but not always, correspond to a significant drop in the debt as well).

There are other ways to hedge tail risk, however, and that is where I come in. I use the very high price they are paying for the tail risk, sell it to them (the 10 and 15 strike puts), and then hedge them with other options of higher strikes. These are trading at much lower implied volatilities (about 30 points lower).

Of course I am taking risk in mismatching the strikes, for by doing so I cannot fully hedge the tail risk: it can be fully hedged as long as the stock does not drop 30 points without trading. If the stock opened at 15 or even 10 straight from 35, I would still be fine; it would have to trade straight to 7 to create a problem.

The other risk is dividend risk. The "out of the money" puts I am short will change in value at a different rate than the "in the money" puts I am long if the company cuts the dividend. I know what that rate is and I think I have a handle on the probabilities of various magnitudes of a cut (our analysis shows that a probability of a cut is lower than what the market makers are assigning as dictated by the option prices). I then create a ratio (selling more 15 strike puts than I buy in the higher strikes) to reflect these probabilities.

One comment on how I am building this position. I know that the credit funds are large and must buy huge amounts of these puts against their debt. I know how much debt is outstanding and then determine how many puts they would buy to hedge their tail risk. When they come in to buy I only sell a portion, selling the puts at higher and higher implied volatilities as the buyers stretch for liquidity. I have a target size. I am about halfway there as I think there is still a lot of demand for these puts.

Why doesn't the credit hedge fund spend a little time and effort in hedging their tail risk a little more effectively by doing what I am doing? For the same reason I am not buying the credit: we lack each other's expertise. Maybe I should hire him.
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Position in RJR

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