In a bid to preserve groupthink, and to finally let Getco off the hook from going chapter if GM's price were to ever drop below $33, JPM's Equity Derivatives desk led by Adam Rudd, who is recommending a trade based on Himanshu Patel's view that GM is massively undervalued, has just come out with a trade recommendation to buy GM March $38 calls funded by selling Ford $17 calls. After all can't let a government funded post-reorg story ever go to waste. And for JPM's functioning retard clients, here is the trade's explanation: "We believe that this trade may be particularly attractive for those investors who anticipate outperformance of GM relative to Ford." One quick look behind the scenes indicates that this call is nothing more than a less than glaringly obvious attempt to recreate the options trading frenzy seen in Ford stock in mid/late October in GM, now that Ford derivatives mania is over.
From the report, which seeks to open a new room in the 2011 hedge fund hotel, which is already chock full with a variety of other names, but most notably Apple, which has been occupying the presidential suite for two years now...
We recommend buying March $38 (~103%) calls on GM for $1.55 (~4.2%) and selling March $17 (~101%) calls on Ford for $0.91 (~5.4%) for a net credit of around 1.2%. This strategy is known as a call switch trade (selling a call on one stock to fund a call on another stock). In this way, an investor has a long GM/short F position, in a rally. If both stocks are below their respective strike prices at expiry, the investor would simply retain the 1.2% net premium that is received upon entering the trade. Figure 1 shows the scenarios (GM and Ford share price moves between now and March expiry) under which the call switch trade would generate either a profit or a loss.
What is surprising is that while JPM is obviously going all out on GM, it is throwing out that other momentum driven name, F, which is likely about to see a short-term top based on this call:
This option strategy would provide a positive return if the Ford share price is at or below the $17 strike at March expiry and/or if GM outperforms Ford by more than 0.6%. This figure represents the difference between the 1.2% net premium received and the % spread between the relative strikes (the GM call is 3.1% out-of-the-money while the F call is only 1.3% out-of-the-money). If both stocks are below their respective strike prices, the net 1.2% premium would simply be retained.
In Figure 2 we show the relative strike for the calls on both stocks. In order to make the time series comparable, we set the Ford share price equal to 100 on December 31, 2009 and then set the GM level (based on the GM closing price on the stock’s first day of trading, November 18, of $34.19) equal to the Ford level on that date (161). Since then, GM has slightly outperformed Ford, up 7.8% compared to Ford up 4.2%. The dotted lines show the relative strikes for the respective call options. Investors would receive a net premium of 1.2% of notional for selling the Ford March $17 call and at the same time buying the GM March $38 call. The dotted blue line reflects the GM strike relative to the current share price after adjusting for this net premium.
And luckily for latency-arb traders based out of Chicago, the liquidity in the options is great enough to even accomodate HFT strategies. We are confident GM options will be the next flash crash strange attractor once the HFT "DMMs" take over. In fact, as the chart below shows, the plunge in F option liquidity simply means that the whole point of this recommendation is to attempt to recreate the same option HFT feeding frenzy seen in late October in Ford options.
The average daily options value traded for GM since options on the stock started trading on November 29, 2010 is around $140m. During this time, the outstanding open interest for calls and puts for all listed maturities has increased steadily to around $1.4bn (see blue lines in Figure 3). The average daily options value traded for Ford remains higher than that for GM: the average daily options value traded for F since November 29 is around $185m and over the last year has averaged around $200m. The total open interest for calls and puts on F for all listed maturities is currently around $6.4bn (see grey lines in Figure 3).
Given Ford’s slightly larger market capitalization ($63bn compared to GM’s $55bn market cap) and potentially higher volatility (given Ford’s higher debt leverage compared to GM’s), the Ford option volumes may remain slightly higher than GM’s option volumes. However, both stocks already have satisfactory options liquidity and therefore investors may find options a convenient way to express a particular view on these stocks.