Monday, August 20, 2007

Bears Got Mauled on Friday

The WSJ Market Beat Blog has an interesting note about who got hurt by Friday's discount rate cut. You probably missed it, but Friday was also option expiration day for index options and those who were long puts got burned badly:

While the Fed’s move helped many investors last Friday, it slammed a handful who’d wagered that the market would continue to decline. It was especially painful to those who had purchased certain monthly “put” options tied to the Standard & Poor’s 500-stock index, which are contracts that pay off if the index declines below a certain level. Those options expired almost immediately after the opening bell Friday.

Index options settle Friday morning at the open, so the Fed's decision to cut the discount rate before the open costs these guys a lot of money that seemed a sure thing the day before:

Investors holding S&P puts that would pay off if the index opened Friday below 1450, for instance, would have made money without the Fed’s action, since the index closed at 1411 Thursday and was moving lower in overnight trading. Instead, the index shot up at the open, pushing the exercise settlement value of the contract above 1450 (1450.11, to be exact — see chart of S&P futures at right).

That qualifies as a bad day in my book. Of course, the option market works both ways, so call holders who looked hopelessly out of the money Thursday evening made out like bandits Friday morning.

The interesting thing about this to me is the Fed's timing. The put holders were probably also buying futures in an attempt to make back some of what they lost, so they helped to push the market higher. Did the Fed factor this into it's decision? I hate to give them more credit than they are due, but my guess is that option expiration day represented an opportunity the Fed did not want to miss.

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