However, there is one tool that escapes the attention of most traders (or rather amateurs) that professionals use, not only to reduce risk but also to influence trades in stock markets. The tool that they employ is Equity Options. How they use it to their advantage?
1. Block Trading
Block trading refers to the buying and selling of large number of shares in a particular security. It normally refers to hundreds of thousands or probably millions of shares and they are common in the security industry. That is why some brokers have a special department just to handle such trades because it is very profitable.
Take for example Broker Morgan Stanley (MS), receives an order from an investor to sell 500,000 shares of IBM at $100 a share. The investor is not interested in staggered sales or selling by small amounts, which may take up to two months to dispose. The investor wants to get it done ‘all in one shot’. So, MS needs to call up other brokers if they are interested to take up 500,000 shares in IBM at $100 a share. Getting someone to take up the offer is not easy. Say if they found someone who is interested in only buying 400,000 shares, what is MS going to do with the remaining 100,000 shares?
MS will have the following options.
- Sell 400,000 shares to the client and 100,000 in the open market
- Sell 400,000 shares to the client and sell a call option on IBM
- Sell 400,000 shares to the client and buy a put option on IBM
Option A will force MS to sell 100,000 shares of IBM at $100 in the open market. By selling such a large block in the open market will tend to arouse attention among other investors and hence might push down the price of IBM shares to below $100. In this case, MS will incur a loss on itself, which is not a good strategy.
Option B will be a better strategy and MS may execute the following.
Sell 1000 IBM Aug 100 Call – Premium 5
So, what the above strategy does is, Sell 1000 IBM Call Options, which is100,000 shares (1000 x 100 shares) and in this case there is no risk because MS had already in possession of 100,000 IBM shares from the investor. By selling the 1000 options, it is in a position to receive a 5 points premium, which is amounted to (100,000 x 5 = $500,000).
But in this case, there is a downside risk associated with selling a call option. If the stock price of IBM shares were to go down to below $100 then MS will incur a loss.
Option C will be to buy a put option on IBM, which can be illustrated below.
Buy 1000 IBM Aug 100 Put – Premium 3
Say if the IBM share is now trading at $95 then you will have a profit of $5 ($100 - $95) x 100,000 shares, which is equivalent to $500,000. Therefore, the Put option will be more valuable if the Stock price is decreasing and less valuable if the Exercise price is increasing because profit is equivalent to Exercise price – Stock Price. But buying a put, MS’s profit will be lesser because it has to pay a premium of $300,000 (1000 x 100 shares) x 3 points premium. So, MS profit will only be $200,000 but his risk in protected should IBM share price rise above $100.
But professionals are different from amateurs, they will rather take a risk and make a profit than to just receive a commission for doing the trade. So, professionals will rather go for Option B rather than the rest because it is their job to manage risk. Amateurs probably, will be better off by buying the put and pay the premium, because their risks are protected.
Similarly, block trades can be employed to facilitate large buy orders of shares in a company.
2. Acquiring large position in a company
Investors may use options to disguise their activities in the stock markets. If they are interested to acquire a large position in a company (AB) say 1 million shares, they may do so in the following methods.
- buy all of the shares in the open market
- buy half using call options of AB and the other half through open market
Option B will be a better strategy and the investors may execute the following.
Buy 5000 AB Aug 100 Calls – Premium 3
So, what the above strategy does is to buy 5000 AB Call Options, which is 500,000 shares (5000 x 100 shares) and pay a 3 points premium, which amounts to (500,000 x 3 = $1,500,000).
In this case, he can buy the shares in the stock exchange without arousing any attention to his activities. He can slowly take his time to accumulate his shares quietly in the stock market while at the same time he purchase 5000 AB Aug 100 Call options.
Since purchase of option is not reported as part of AB’s trading volume and hence other investor’s will not know of his intentions. Also, purchasing of options will not alter the daily trading volume of AB, it will be ‘easier to collect’ his required amount of shares.
Hence, the use of options helped the investors to accumulate their required amount of shares in a particular company, without arousing much attention of other investors, which might make it difficult for them to achieve their goal.
3. Insider Trading
Company Directors, Financial Controllers and Insiders, may use options to hide their activities in the stock markets. If they are in the know that there are good news pertaining to their company such as a larger than expected profit, a Merger or Acquisition activity, a large find of mineral reserve and etc. Instead of buying or accumulating of shares of their company in the open market, they may buy call options of their company.
When the good news is reported, they can cash in their call options. But they might be under the scrutiny of the Securities Commission, as call options is also known as stock equivalents. Since call options can be converted to shares, they may be subjected to insider trading. However, they can get around it by purchasing it under someone else name such as their relatives or some sort.
Similarly, this also applies when Insiders may use options to capitalize on the bad news of their company. If they know that their company will be reporting a larger than expected loss or the canceling of a Merger and Acquisition agreement, they can buy a Put Option. So when the bad news is announced, the price of the underlying security will go down and hence the price of options. So they just exercise their put option for a profit.
4. Hostile or Management Takeover
Due to the diverse amount of shareholders, the ownership of some companies are rather thinly distributed. Sometimes, a 5-10% ownership of the company shares is considered substantial. These companies are prime target for hostile or management takeovers. If an outsider wants to gain control of the company, all they need is to quietly purchase a 10% stake in the company. They can do it through the options market without arousing the attention of the management. By the time they have accumulated enough options, they can exercise it and they will automatically become a substantial shareholder.
When they have gain control of the company, then can blackmail the current management by threatening to discharge the whole management. So in order not lose their jobs and the perks that come with it, the management had to conformed to their demand by buying back their shares at a higher price.
The SEC in trying to control such activities enacted Rule 13D, which requires any individual that owns 5% or more of a corporation stocks to file a report. Again, investors can get around it by purchasing the stake with different names.
5. Selling large Block of shares in thinly traded stocks
If an investor is holding a block of 500,000 units ABC shares, which only trades about 2000-3000 shares a day. How can he get rid of his shares within a short period of time say one week? Should he dispose the whole block of ABC shares in the open market, it will crash the share price of ABC. Say if the price of ABC shares is trading at $30. What strategy should the investor employ to sell the shares without hurting its share price?
The answer is the following.
Buy 5000 ABC Aug 31 put – Premium 2
By buying the put it will cost him a 2 points premium. Always remember you will receive the premium when you sell an option and vice versa. So when August arrives, he will exercise his option and deliver his 500,000 shares at the price of $31. After subtracting the premium, he is actually getting $29 for his block of shares. It will be much better selling it in the open market because by doing so he might drive the shares price below $29 and most probably to $25.
So, finally as you can see, there are many uses of options, not only to trade but also to maneuver your trading strategies in the market. Another use of option, is to help corporations to hedge their risk in their global operations. This will require another article, which I will later address on how Multinational Corporations use Currency Options and Forward Contracts to hedge their foreign exchange exposure in international markets.