If it's too good to be true.......

In options trading there is no such thing as a stupid question. The Prepared Mind is constantly asking questions as it models and reviews the potential of different strategies. During my 26 years of trading, I have found one maxim to be always true when reviewing a potential trade: If it looks too good to be true, it is not true. This is something which is an immutable fact. I am not going to find the Holy Grail of trades before Goldman Sachs and other large hedge funds with super computers doing millions of calculations a second. My edge comes from a disciplined art of trading which is not easily duplicated by a machine. The Prepared Mind is a remora swimming in and out of the mouths of financial sharks gaining consistent financial sustenance from what the sharks cannot be bothered with.

This fact was highlighted by an email I received from one of my mentoring students: “Have you checked out the The St. Joe Company? The symbol is JOE. It is in a squeeze play. The premium on the puts is about twice that of the calls. If you can put on a synthetic long with the options and then go short the stock, you lock in a significant yield for a 1.5 month hold. This yield is 100% probability of profit according to my risk analysis software and volatility changes don’t affect it Can you see any problems with this trade? It looks like a sure bet to me. The position is short 100 JOE and long 1 Mar 28 call and short 1 Mar 28 put. Check it out. ”Kudos to the writer of the email. He did not execute the trade immediately. He tried to determine why the risk model looked the way it did.

I knew immediately it was not a sure bet; it was too good to be true. The Prepared Mind needs to determine the source of the disparity between the synthetic long, created by the options, and the short stock position. The clue to the answer lies in the fact that the position included short stock.

The strategy employed in the example is a reversal. A reversal is:
• Short 100 shares of the underlying stock
• Long a call option and short a put option at the same strike price
At the beginning of my career, I did not have access to theoretical option prices or any of the Greeks. I priced my options based on the relationship between puts, calls and the underlying. I calculated by hand my markets for the reversals and conversions (the opposite strategy from a reversal) on a daily basis. The reversals and conversions were used to maintain the relationships between calls, puts, and the stock in different months.
Based on this early experience, I knew the disparity came from one of two sources: the interest rate on the short stock or from a dividend. When a stock is shorted,, the seller is responsible for paying the dividend. I have seen this disparity in ADRs where a the market does not know which month a declared dividend will be paid in. In addition, I have seen the same disparity occur when the rumor mill suggests that a special one-time dividend may be in the offing. My research showed there was no dividend – rumored or declared. That left the short stock as the source of the disparity.

Short stock is “borrowed” from someone who is long the stock. It is either easy-to-borrow or hard-to-borrow. Historically, retail traders were not allowed to short hard-to-borrow issues. Recent changes in the stock borrowing business have resulted in a change in this policy. The investor who shorts the stock must pay for the right to have a short in a hard-to-borrow equity. This cost is expressed as a negative percentage rate. In the case of The Saint Joe Company (JOE) the cost is -59.0%. This means the cost of shorting $1,000 of JOE would be $590 on an annualized basis. In the example we discussed, the cost is:

$28(Strike Price)*-0.59(short stock cost)*100(shares of stock)*45/365(days carried) =
$203.67.

In other words, it costs $2.04 per share to short one share of JOE for 45 days. The risk analysis software did not know the stock was hard-to-borrow.
Develop the Prepared Mind. It is the trader’s responsibility to know if a stock is hard to borrow. Most brokers do not publish a hard to borrow list or the interest rate charge to short the stock. You must call the trade desk to determine the availability and cost of short stock. Very few, if any, risk analysis programs automatically calculate the impact of the effect of hard-to-borrow stock. Do not trade anything in an information vacuum. It is your responsibility to know the impact of dividends and stock carry charges upon what you are trading.

If it looks too good to be true, it is not true.