Speculating on Sino-Forest

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www.bnn.ca/Blogs/2011/...orest.aspx


.......The Canada Pension Plan holds more than two million shares valued at $46 million. Of course that is all before the recent sell-off in the shares.
......Investors who do not own the shares have a dilemma. If you are aggressive, and are willing to take the company’s side of this, you would buy the stock. If proof of ownership is actually shown, then the stock probably recovers. Perhaps north of $20 per share. If Muddy Waters turns out to be right, and they have an excellent track record in this area, the stock collapses, likely below Mr. Block’s $1.00 target. It could even bankrupt the company.

In short, any directional trade – i.e. buying or selling the underlying shares - is pure speculation. But if you are willing to look at options as a way to play the outcome, there are alternatives that do not require a directional bias. The question, as with any speculative trade in the Canadian market, is can you actually get the trade on.

The strategy is to buy a straddle, which involves the purchase of a call and a put on the underlying shares. This strategy does not require you to have an opinion as to the outcome, only that an outcome will result in a short time frame.

With a straddle, the calls will profit if the stock rises, and the puts will profit if the stock declines. Which is to say, you are making a bet on future volatility. In this case, betting that Sino-Forest will rise or fall by more than the total cost for the two options.

In order to put some meat on this skeleton, let’s price out the options on Sino-Forest. With the stock at $7.38, the July 7 strike options were trading with an implied volatility of 298%. Anytime options are trading at an implied volatility greater than 100%, you are looking at a purely speculative strategy where the company could actually decline to zero.

Assuming the 298% implied volatility, the Sino-Forest July 7 calls would be valued at $2.75. Using the same assumptions, the Sino-Forest July 7 puts would have a value of $2.45. These options expire on July 16th (last day of trading July 15th). The total cost for the two options then, is $5.20.

If you take the total cost of the two options and 1) add the cost to the strike price ($7.00), and 2) subtract the cost from the strike price, you arrive at the option markets implied trading range for Sino-Forest. In this case, the implied trading range for the next 37 days is $1.80 ($7.00 strike price less $5.20) to the downside and $12.20 ($7.00 strike price + $5.20) to the upside.

That does not imply that the stock will actually remain in that trading range, it is simply an unbiased estimate from the option’s market as it tries to put a number on the risks associated with the stock. In much the same way as the current stock price reflects an unbiased view of the market as to the outlook for earnings over the short to medium term.

Speculators would buy these two options if they felt the stock is likely to breech either end of that trading range prior to the July expiration. And that will hinge on how quickly the company is able to get the information in the hands of the independent directors. Like I said… pure speculation.

In fairness the prices quoted for the Sino-Forest options are based on the volatility assumption being used by market makers to price options in the Canadian market. But, as Canadian market makers tend to do, they have left themselves a lot of maneuvering room, by quoting very wide bid asked spreads. At the time of writing (with the stock trading at $7.3, market makers were bidding $2.25 and asking $3.40 for the July 7 calls, and for the July 7 puts had a posted bid of $1.00 and posted ask of $3.35.

The July 7 calls actually traded on Monday, but at the time of writing, the July 7 puts had not traded. That may explain the excessive spread being used on the July 7 puts, but at any level, it means that it may be almost impossible to put the trade on at a price that makes sense.

If you want to implement this trade, I would only do so, if you pay no more than $3.25 for the straddle. And as always, enter the straddle as a limit order– meaning you want to enter the straddle at a specific net debit – and will only accept the trade if both sides are executed at the same time.