Saturday, August 11, 2007

WAMU (WM): An option pricing lesson

Above are the 1 & 2 day 10 minute charts of WM and the 1 day 1 minute chart. The 2 day chart shows where WM opened and closed on Friday relative to Thursday.
My goal was to sell some of the Sept. 40 calls (WMIH), to pick up some premium. Based on the fundamental weakness (and perceived risk) in the financial sector, the odds of WM rebounding above 40 in the next 5 weeks appears slim (this is my opinion, only .. see disclaimer sidebar).
At Thursday's close WMIH was trading 75/85. I had hoped to get a pop up on Friday, but the frogs got loose and as we all know Friday's open was frightful.
WMIH opened 50/70 Friday. We got an S2 bottom kiss at 9:42am (34.52), then reversed at 9:50 and climbed to 36.00 by 10:08am, where WM formed a squat bar for the next twelve minutes. I know the market makers like to play this thing .. one favorite game being to lift the ask just before reversing down.
At 10:15 WMIH was 75/85, so I entered a Sell order at .90 (just trying to play the game, as we had been squatting for 8 minutes and were due for a turn).
The spread went 80/90 at 10:17 as WM hit 36.04. I adjusted my price to .85 and got a quick fill, and the spread immediately dropped to 75/85. I decided to sell some more if I could get my price and entered a new .85 order.
Over the next couple hours WM slowly climbed to 36.45, but my order sat unfilled as the spread actually declined to 70/80.
WM got a quick sell off 12:30-12:50 with the spread 65/80.
For the next 1/2 hour WM climbed up again and at 1:38pm, with WM @ 36.22 and the spread 75/85 I dropped my Sell order to .80 and was filled at 13:43 with WM @ 36.00. Now that was weird .. the price went down,but the option went up.
Over the next hour WM retraced back to S1 (35.64) with a 60/65 spread.
For the final 90 minutes WM again climbed to make the high of the day (36.53) at 3:35, with the spread 65/75.
WM then sank to 36.00 at final close with the spread 60-65. Final adjusted close was 35.75 so the adjusted spread is probably 55/60.

Bottom line. .. I managed to sell the WMIH close to my target relative to the market. The market makers have a bad habit of changing the volatility value on a whim, with resultant option spreads to fit their pricing models. Many times these pricing models are difficult to decipher or to foresee ... which is what makes trading complicated (see previous post for attitude adjustment tool). I suspect we will see the value of WMIH decline rapidly for the next week, regardless of WM's performance. My experience is that calls tend to be relatively expensive the week before expiration and relatively cheap the week following expiration. This is part of the market maker game to make rollovers a bit more expensive for you. At the same time, mid-expiration spreads are typically smaller than either the week before or week after expiration.

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