Looking at the Jan 2010 17.5 strike calls in McGraw-Hill (NYSE: MHP, Stock Forum), we find that they traded 40,000 times in the first four hours of trading Wednesday. The current open interest was a mere 12 contracts according, to the Sidewinder report at www.onn.tv. What is interesting about this call activity is that most of the activity stemmed from call buyers.
At first glance, this trade appears very bullish, and it probably is. However, a closer look shows that these options traded with stock, meaning that the call buyer simultaneously sold shares to the option market makers. The options hit the time and sales at roughly 12:08 EST at a price of 4.75. A look at the time and sales for MHP shares shows that 2.4 million shares traded at $18.25 around the time of the option trade. The block of 2.4 million is the number of shares that would need to be bought by the option sellers to make this trade delta neutral. So the fact that the investor did a delta neutral trade could mean they are more interested in betting on volatility than direction. The price of $4.75 in the calls with stock at $18.25 is an implied volatility of 71. The historical volatility for the last three months is 62. So if this investor thinks that MHP will be more volatile than in the past, then purchasing options with an implied volatility of 71 will make money for the investor if they are hedged daily until expiration.
I think, however, that this trade is still bullish because the investor has likely sold the stock to the option market makers to control the price jump in the stock caused by the market makers buying the stock in the open market. This way, the investor has managed to only purchase volatility from the market makers rather than delta. This enables the investor to get a cheaper options price because the option market makers do not have to take stock price risk at the time of the option sale. This allows the investor to keep the purchase of the stock more anonymous. The investor may have bought the stock in the market prior to buying the calls. The investor’s hope is that the price that is paid for the shares will be less than what would have been implied in the option price if the market makers were left to buy their hedge at the time of selling the calls.
MHP has been a part of the financial crisis because it is the owner of one of the bond-rating agencies, Standard & Poor’s. Investors are concerned that there could eventually be litigation risk stemming from some of the bond ratings that Standard & Poor’s placed on mortgage-backed securities. The bull case had been that despite the litigation threat, the publishing business was doing well and without the cloud of litigation, the shares would see an expansion in its P/E multiple. Unfortunately for the bulls, that story has not played out as the stock has dropped more than 50% since September. As we have seen with other call buying in this market, this investor might be preparing him or herself for a potential snap back in the shares.