You do your due-diligence and select a great performing stock in a great performing industry. Once you have determined that this equity meets all of our system requirements, you head off to the option chains to check the calculations. Since the stock is trading @ $39 per share you check the $40 call. This can’t be…there are two call options with a $40 strike price. They have different symbols, volume, open interest and bid-ask prices. One has a bid of $1 and the other a bid of $12. You think to yourself that the market makers must have been out late last night partying and made a huge mistake. I’ll sell the $12 option and make a huge profit. Better yet, I’ll buy thousands of contracts of the cheaper and sell the same number of the more expensive, offset my positions and pocket a fortune. I’m going to be rich! The truth of the matter is, NO YOU’RE NOT! You have entered the world of non-standard options.
What are non-standard (NS) options? :
These are options that don’t have the standard terms of an options contract, namely 100 shares as the underlying asset. They are normally created as a result of a specific event such as a merger, acquisition, spin-off, extraordinary dividend or stock split. As a result of the changing circumstances, the contract is adjusted to be equitable to both the option buyer and seller by equating the new underlying asset(s) of equal value as the owner of 100 shares. The Depository Trust Company (DTC) determines how the shares will trade pre-event while the Options Clearing Corp. (OCC) decides how these changes will be reflected in the options. Each situation is unique and therefore non-standard. This makes them difficult to understand and therefore risky to most investors. In the above hypothetical, one contract was a standard options contract, the other non-standard. The standard contract represents 100 shares of the underlying, while the NS contract does not. As an example, when BAC took over Merill Lynch, the owner of 100 shares of Merill received 85 shares of BAC stock plus $13.71 in cash. NS contracts of BAC now would deliver 85 shares of BAC + the cash as opposed to the standard contracts which represented 100 shares. The obvious rule is avoid all non-standard options. Let me add another: if an option value seems too good to be true, it is. These contracts will also show odd strike prices and different root symbols.
Real life options chain for BAC showing standard and NS options:
I have highlighted the two $5 strike options. BYO DE is the standard option which represents 100 shares of BAC while JLW DA is the non-standard reprersenting 85 shares of BAC + cash. An uninformed investor looking to buy an option would think the NS option is a much better deal, costing $179 per contract as opposed to $254 per contract. The caveat is that the former will deliver only 85 shares (+ cash), not 100 shares.
Liquidity of NS Options:
These contracts are often illiquid and difficult to trade. In this chart, we can see the volume of the standard contract is 3990 compared to the 209 for the NS contract. When evaluating the liquidity based on open interest, one can easily be deceived as many of those option holders had their contracts since prior to the merger. Most likely there has been little activity in them since.
Timing of contract adjustments:
When contract adjustment is needed as a result of the aforementioned events, the standard (“plain vanilla”) options are adjusted accordingly. When a new option comes into existence after the event, it will appear as a standard option. ****Check with your brokerage company to make sure that you will be notified, prior to execution, if attempting to trade a NS option.
Free information on contract adjustments:
Non-standard options result from an asset-changing event like a merger or spin-off. They are difficult to understand because each is unique to its particular situation. When we see a premium that makes no sense and there are two similar strikes, avoid the NS option and stick to the one we know and understand.
Chart of the Week- WIT:
The following points should be noted:
- This stock passes our system screens as described in my first book, Cashing in on Covered Calls
- The blue arrow shows the price bars at or above an uptrending 20-d ema
- The red arrow shows the 100-d ema below the shorter-term ema, also uptrending
- The green oval shows the MACD positive as is the histogram below it
- The orange oval shows the stochastic oscillator in the overbought, but holding position
- Note that volume declined during the holidays as it dropped below the average volume (yellow line)
Economic News of the Week:
Consumer confidence rose for the second consecutive month demonstrating a more positive outlook for the future. The index, however, is still historically low. For the week, the S&P 500 declined by 1.0% for a total year return of 27%.
Next Week’s Economic Reports:
- Monday: Latest survey of the manufacturing sector, construction spending
- Tuesday: Factory orders
- Wednesday: FOMC minutes, latest survey of the service sector
- Friday: Consumer credit, payroll jobs, unemployment rate
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Wishing you all a happy, healthy and wealthy 2010,
Alan ([email protected])