It’s official, you were able to agree to purchase LinkedIn BELOW its IPO price after the IPO. The magic of the market through which this can occur is the much maligned derivative instrument, more specifically in this case, the short put.
During the first day of options trading, LinkedIn put options were trading with implied volatility levels twice the level of equivalent call options. The implication from the inflated prices was that the market was placing greater likelihood on LinkedIn falling in price than on it rising.
One cause for this expectation is that limited supply of stock was available to borrow and short, leaving put instruments as the only viable alternative by which to benefit from a decline in stock price. Another cause is that the supply of shares which can be sold following the lock-up period is over twice the current float, which should inevitably lead to downward price pressure.
But the lock-up period should be very closely examined by traders feeling comfortable that the stock has greater forces of demand than supply until that date. The option prices provide a clue into why traders should look at the fine print to see why this is a dangerous assumption to make.
The implied volatility on the put options isn’t just high for one month or two months or even three but it remains high all the way out until February of 2012. That suggests tremendous uncertainty in the market about when the stock might suffer from the supply of shares coming online. The question is why is the market so uncertain?
Looking at the fine print, the decision to release further shares onto the market is at the sole discretion of the underwriter, Morgan Stanley. They could choose to release shares earlier than the anticipated lock-up period or indeed later! That leads to tremendous uncertainty in the market place.
It also offers traders a chance to capitalize on exceedingly high put premiums. And not necessarily by buying them but potentially by selling them. For example, a short put at strike 50 in Feb 2012 was selling at $5.20 on the opening day’s trading. That meant a trader could get paid $5.20 to agree to purchase the stock at $50 next February in the event that the stock was trading below $50. In effect, traders were agreeing to purchase the stock at a price of $44.80 ($50-$5.20), which is below the IPO price.
Often selling the premiums that soar during moments of excess can be very lucrative in the long-term. These opportunities don’t come along often but when they do, the reward to risk ratio can prove very compelling.
Also on Market Tamer…
Follow Us on Facebook