We received an interesting note from George Gero at RBC today for which we thank him. First the facts
- This morning, someone traded a large block of Silver Options
- The options were June $21.00 calls
- The volume traded was 3,100 lots at a price of 16.3 cents
- that translates to approximately 2.56% of the aggregate open interest.
- The initiating interest was apparently from the sell side as the price was a full Vol under previous.
- The option delta was 15 and is not typical of producer delta choice.
- The price is right where Silver failed last July.
Heres the Tape:
Here's the Option Value Charted. OUCH
If the initiating interest was from the sell side, the knee jerk reaction from people is to call it a bearish trade. This could be true. But history adn experience tell us that is not the case in a large majority where calls are slammed. Frequently we test the strike at least before dumping. Here are the most probable reasons someone would sell silver calls in this fashion and a quick analysis in italics after each
- Bearish Speculation- this is not a smart thing to do. Silver options are a roach motel, and it is almost impossible to exit when one has to.
- Informed Player Trade- a dealer with flow on his book like a massive sell order in futures. He can take a punt knowing he has a brick wall above the market to use- this is unlikely as prop desks do not take that kind of indirect risk these days. Selling calls because of a futures sell order is not advised
- Informed Flow Trade 2- a client has options to sell or did sell on a deal to hedge production, the dealer merely added an implicit fee and scalped his client- less likely than in the past, due to screen transparency. If true, more likely from a foreign client with no tech or option savvy.
- Bullish Fund- a long fund with a price target of (say..) $20.00 decides they will sell $21 calls to create a dividend and if the market spikes above their target, they will either hold their futures or roll their short call higher- covered call writing essentially
Here are the Leading Candidates Based on Experience and Info
The Strangle Seller:
For years there was a Fund/ CTO/ CTA who made his living selling strangles and collecting premiums. This "fund" would grind out a decent return for years at a time for his investors with no real accounting for VaR of his clients. Every 6 months or so, he'd blow up. Then he'd raise new money and start over.Here is how he'd execute/manage risk
- sell calls at an opportune moment- sometimes in a rally, sometimes in a sell-off
- Sell puts using the same approach, thereby legging into a strangle short
- If an option became dangerously close to blowing him up, he's roll the short higher (calls) or lower (puts)
- He would sometimes sell more puts in a rally to raise premium while rolling his short call higher. essentially a 3-way trade.
- He would throw in the towel by just covering the short option causing him grief and hoping the other leg was worthless.
What to watch for: If a similar size block trades on the put side, you have your confirmation that this is a strangle seller. And you have a likely path of future behavior if things go poorly for the short.
The Massive Futures Sell Order By Captive Client or Fund:
No conspiracies here. a fund, dealer, or some player is long (or not). There is a sizeable order above the market near $21.00 to sell futures. Even better, a Market-if-Touched type of order. An options trader at the firm decides to sell calls knowing this, and he has access to take the other side of the sell order if the market gets away from him. Classic "non conflict" flow trade (if a dealing bank) as the futures desk is not selling in front of the CAPTIVE client order.
What to watch for: the market hits $21.00 adn several things may happen. 1) a massive selloff at least the first time up. 2) if no options trade then assume the short does not care 3) next time up, the selling might not be there as the short option guy took it out, and now wants the market to go higher so his negative gamma doesn't force him to turn seller.
The Investor Covered Call Game
The Smart Producer Hedge
Miner wants stock to continue to perform on upside with Silver price and has large operating leverage. Therefore he decides not to hedge production in futures but instead sells calls. Likely candidates include miners whose CEO gets stock as bonus. Also not uncommon for producer to buy teeny calls against a sale of meaty calls to participate in the Armageddon trade.
The Player Covered Call Game
Or alternatively, this is a Player who is long futures form a much lower price, and 3100 calls are a tiny portion of his long position. A firm like PhiBro would be happy to buy those calls back as sloppily as they could, knowing the marketmaker hedges would drive their futures up substantially. They made their living in energy doing things like this. They also liked to buy calls hard when they were selling their long futures tocreate exit liquidity. In theend they'd be long synthetic puts, adn short an additional boatload offutures.
The Producer Hedge Trade Pinned Strike:
We will pin 21 at expiry at best Why? Because the seller has a ton of futures more to sell than the calls he sold.
The Producer Sap Trade
This is a fun one, but very rare. The producer has decided to not hedge production via futures but instead sells calls to lower his cost basis. Simple idea. Usually makes sense if the miner has free cash flow.
Problems arise in a rally when he has the silver for delivery but can't make the margin call on the short options. A classic example was the Ashanti-Cambior fiasco in 1999. These miners needed financing and the banks that gave it to them also took the other side of their short calls. Then, Y2K nonsense causes a rally. Ashanti cant make the margin call, their credit line is closed, the bank prop desk buys futures for itself, and the client pays 99% vol covering its short options through the same bank. Bonus: The bank oversees the liquidation and sale of Ashanti to its new owner,. Anglo Gold.
Unknown Unknowns and JP Morgan
To be sure we do not know every possibility. The most important thing to know is the type of seller.
Producer, Intermediary, Fund, or Player. The future market behavior helps narrow the choices of the trader. Right now, we'd assume nothing and look for a massive put sale. If one comes in, then we know that the short is a non-Player spec susceptible to being wrong, and will act if he is.
One should also remember that if a massive trade in Silver goes down, JP Morgan either is involved or knows about it. So watch their behavior, and assume nothing directionally.