Merrill Options Trading `Stood Out' Prior to Loss

By Jeff Kearns

July 29 (Bloomberg) -- Traders who bought Merrill Lynch & Co. options yesterday betting the biggest U.S. brokerage would extend its worst slide in 21 years may have been tipped off, options analysts say.

Merrill options rose to the highest in almost two weeks yesterday and traders increased bearish bets hours before the firm said that it would take $5.7 billion in writedowns. The stock rose 7.9 percent today, its first advance in five days.

``I got a lot of calls from people saying, `Why so much volume in the puts?' I had no idea,'' said Steve Sosnick, a market maker at Greenwich, Connecticut-based Interactive Brokers Group Inc., which handles one-seventh of all equity options traded worldwide. ``When I see the news come out after the close, it makes me suspicious that somehow this got out.''

Jessica Oppenheim, a Merrill spokeswoman, and John Heine, a spokesman for the Securities and Exchange Commission, declined to comment. Merrill added $1.92 to $26.25 in New York after investors bet Chief Executive Officer John Thain eliminated the company's subprime mortgage risk.

Implied volatility, the key gauge of options prices, jumped to 109.2 yesterday as Merrill shares lost 12 percent. Two days earlier, implied volatility rose to 87.11 and the shares dropped 14 percent. Merrill's stock fell 29 percent from July 22 through yesterday, the worst four-day slide since October 1987.

`This Stood Out'

The most-traded Merrill options yesterday were contracts that give the right to sell at $25 by Aug. 15, followed by August $22.50 puts. Merrill closed at $24.41. The contracts made up almost a quarter of all Merrill options traded yesterday.

The $22.50 puts lost 69 percent today, while the $25 contracts lost 58 percent, reversing earlier gains of 41 percent and 25 percent, respectively.

Michael McCarty, an options strategist at Meridian Equity Partners Inc. in New York who writes a daily report to clients on unusual and unexplained trading, cited Merrill's August $25 puts in his note yesterday.

``This stood out,'' he said. ``The implied volatility jumped quite a bit for a single day and considering the context of where the market was and where the stock was trading, it was an outsized move.''

Merrill said after yesterday's close of U.S. exchanges that it sold $8.55 billion of stock and will book $5.7 billion of writedowns in the third quarter. The brokerage also said it will liquidate $30.6 billion of bonds at a fifth of their face value to shore up credit ratings imperiled by mortgage losses. Trading of puts on Merrill was almost twice the call volume yesterday, when the August $25 puts added 56 percent to $3.20 and the August $22.50 puts rose 58 percent to $2.09.

`A Leak'

``It hints that possibly there was a leak,'' said Frederic Ruffy, the senior options strategist at WhatsTrading.com, a New York-based provider of options market analysis. ``There was a lot of defensive, bearish trading in the options leading up to the announcement yesterday, suggesting that some investors were preparing for bad news.''

Pat Neal, head of equity derivatives strategy at Jefferies Group Inc. in New York, said the options trading and volatility increase were to be expected after the shares declined.

``The stock got clobbered the last couple days, so clearly people were expecting something to occur,'' Neal said. ``Implied volatility was up, but it's not unexpected given the change in spot price.''

To contact the reporter on this story: Jeff Kearns in New York at jkearns3@bloomberg.net.