Thursday, April 13, 2006

Weird Options: Dealing With Spin-Offs

Market blurb: Given the recent break the indices have held up well and my get tells me there's strength in them. That strength is likely being held down by the usual expiration factors, so even though I am bullish on the broad market, I'll hold any move suspect. After the slide we sold a set of put verticals on NDX-100 and OEX and left it at that. I am also putting our fund's money into long OEX May 585 calls on downticks with a view at a run higher after the expiration sorts itself out (as described in my Sunday post).

Here is a bit of trivia: what do you do when you hold options on a stock that does a spin-off (meaning, restructures a part of itself as a different company)? As a member of a market making operation some years ago I had to deal with sort of thing (and other kinds of annoying corporate actions) all the time. However, after having founded Cadence I luckily haven't run into this sort of a situation for a long time... until now. Here is the gist of it:

I sold some KMG (Kerr-Mcgee) 105 calls a while ago and a few weeks later found these same options in my portfolio under a different symbol than I remembered (the root used to be KMG and now it's KMO). More importantly, these options suddenly became much more expensive than what I paid for them, even though KMG (the underlying) hasn't changed in price all that much. Or so it appeared.

Of course after a minute of gazing at the price I realized what happened: KMG spun off a new company effective (ex-date) March 31st. In this case, the newly formed company (Tronox Inc.) was listed under TRX.B symbol on the NYSE and "took" $0.20164 from KMG's original stock for every dollar of its new share price. This is otherwise known as a "distribution". When TRX.B opened on March 31st the price was $17.75 per share which meant that $17.75*0.20 (roughly) was the amount by which each share of KMG had to be reduced. Doing the arithmetic, the reduction comes out to be $3.55 per share. On March 30th KMG closed at 99.51 to open the next day at 96.00. Close enough. So, as of March 31st, KMG had a newly spun-off company, TRX.B trading along its side with bunch of KMG's "money" invested into it via this so-called distribution.

Great, so what happened to the options? Well, since the options I held were the "original" KMG options (pre-distribution), they were tied to the original KMG price. Now that KMG got chopped by $3.55 per share because of the spin-off, the options needed to be adjusted accordingly. One of the ways to do this was to create a new "synthetic" underlying priced according to the combination of the "new" KMG and TRX.B. In essence, the new underlying price would then become KMG+0.20*TRX.B. Trivially, this synthetic underlying would reflect the old price of KMG, pre-distribution, but be tracked under the new KMG and TRX.B, reflecting the behaviors of both stocks, as intended.

That's exactly what was done. The only (minor) issue is that now you, the trader (or me, in this case!) have to create the synthetic price all by yourself. In my case I was negligent to do so and only noticed the change when the options went from the original price of about $0.95 to over $2.00. You'll probably realize at this point that the options went up in price because KMG rallied back to 100 and even higher. Of course, since the options were now tracked by the synthetic underlying, the actual underlying price was close to 105, which put the options at the money and inflated their price.

The lesson here is to watch your corporate actions carefully. Whether you're a die-hard technician or not, looking at stock charts certainly isn't going to be enough (I mean, we're short KMG calls, the stock drops 4 points, that's great, right?). So, add "spin-offs and acquisitions" to your list of things to track, right next to dividends and splits.

Tongue-in-cheek: By the way, KMG's retracement up to 103 from its March 10 low is exactly at 0.618 Fibonacci level (off the high of 110). That does not include the $3.55 "discount". So, Fib traders out there, explain that one! :) Just more evidence that things a lot more random than we choose to believe.

Have a great long weekend!

Cheers,
/Dmitry

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