Options Contracts Can Get Weird

Yesterday morning, a reporter called me with a fascinating question.  She noticed that about 500,000 of the $2.5 strike November calls on Bright Health Group (BHG) had been purchased for roughly 10 cents, yet the stock was trading about $14.  “How could this be possible?”, she understandably asked.  Well, I’m glad she chose to reach out to me, because this is exactly the sort of detective work that I enjoy. 

Spoiler alert, here is the resulting article by Bloomberg’s Carly Wanna.  I highly recommend reading it, but only after you pore through the arcana that underlies it. 

Ms. Wanna was quite right to be skeptical, since the options appeared to trade several dollars below what should have been their intrinsic value yet were still offered at their traded price.  Intuitively, it sounded to me as though there must have been a change in contract specifications, but knowing little about the company, I needed to do some digging first. 

My first move was to try to see what she was seeing.  Knowing that she uses a Bloomberg terminal, I pulled up the options on their system and indeed saw that they were showing what she described.  Needing a second opinion, I went to the IB TWS, but no options came up under the symbol BHG.  Hmmm…

So, I went back to Bloomberg to look very closely at the options in question, and it turns out that the options class was actually BHG1.  That is a huge tell.  When the Options Clearing Corporation (OCC) adjusts the contracts on stocks that have undergone a major corporate action, they usually append a number to the resulting basket.  Sure enough, the TWS shows those options under the symbol BHG1. 

Knowing that my intuition was indeed correct – over 2 decades spent as an options market maker tend to shape one’s intuition about options contracts – I knew that my next move was to go to the OCC’s website, www.theocc.com, to search for memos about BHG1.  It didn’t take long to find two recent memos about that contract.

The first memo, from May 19^th, explained that the company would be undergoing a 1:80 (yes, one for 80(!)), or .0125:1 reverse split.  Remember, equity options contracts typically deliver 100 shares of the underlying stock.  The BHG options that were outstanding prior to the split originally delivered 100 shares of (old) BHG.  As of May 22^nd, the ex-split date, they were reorganized under the new symbol of BHG1 to deliver the resulting 1.25 shares of (new) BHG.

But OCC is not in the business of delivering fractional shares.  As a result, the first memo stated that OCC would be determining a cash-in-lieu amount for the fractional shares.  The second memo, from June 12^th, fixed the cash amount at $2.26 per contract.  It was clearly stated that the deliverable for BHG1 would be 1 share of BHG and $2.26 cash.

The memo also stated that the multiplier would remain at 100.  That may have been a cause of confusion for the buyer.  Anyone who has traded options, personally or professionally, should be quite familiar with having their settlement price being 100x the trade price.  If you buy one option contract for a dollar, you end up paying $100 before any fees and/or commissions.  That is because an options contract’s multiplier is 100.  It is also the reason, as noted above, that options contracts normally deliver 100 shares of the underlying stock.

What it means in the case of BHG1 is that the value of each underlying options contract is just under 17 cents.  Each one delivers 1 share of BHG, worth about $14.50 right now, and $2.29 cash.  That’s $16.79 – but you need to divide by the 100 multiplier!  Thus, $0.1679.  On that basis, a $2.50 strike is a long way away.

Being a good journalist, the reporter asked why someone might buy so many contracts so far out of the money.  Remember, the buyer paid about 10 cents for 500,000 contracts, meaning their outlay was just under $5 million.  I can’t get into someone else’s head, but I offered three theories:

1. They really believe in BHG’s prospects.  We saw some seemingly nutty trades make out well during the meme stock craze.  For this trade to pay off, BHG would need to rally at least 16X by November.  Seems unlikely, but who knows…
2. The buyer thinks they are buying $2.5 calls on an underlying worth $16.79.  Forgetting to divide by 100 is a rookie move, but it happens. 
3. The buyer made a hybrid mistake, understanding that the value of the stock in the contract was about 14.5 cents but adding the full $2.29 to that value.  Paying 10 cents for a $2.5 strike call expiring in four months seems quite reasonable if you think the underlying is worth about $2.44.

The problem with items 2 and 3 is that the buyer didn’t read the market.  The trades happened in tranches, meaning that the sellers didn’t feel the need to raise their prices after their first sales.  That should have been a big tell.  Normally we see prices move higher in the face of aggressive buying.  Instead, the sellers showed remarkable confidence that their sales were all at attractive prices.

Experienced traders know that when a trade seems too good to be true, it usually is.  A series of highly profitable trades in a given options class was a cause of concern, not celebration.  It usually meant we were missing an event, had a dividend amount or date wrong, or something similar.  We raised our prices to avoid any additional trading until we could ascertain whether we were right or wrong.  Too often it was the latter.   In this case, the sellers must have double-checked their calculations and decided that these options were indeed a good sale. 

Bottom line – if a trade seems too good to be true, it usually is.  And unless you are a market maker, you get to decide whether you initiate a trade or not.  Options contracts can be arcane and tricky to understand.  If you think you’ve found a wrinkle that everyone else on the street has missed, you need to double, triple, quadruple check the contract specifications.  Odds are the experienced trader on the other side has already done so.