MorningWord 3/25/15: $KRFT – Gee Whiz

by Dan March 25, 2015 9:07 am • Commentary

A few weeks ago in this space (MorningWord 3/11/15: Cheesy Breakouts) we highlighted what appeared to be some unusual call buying in a fairly sleepy consumer staple stock, Kraft (KRFT):

when the stock was $61.45 a trader paid .70 for 10,000 June 67.50 calls to open. These calls break-even on the upside at $68.20, up 11%, which happens to be a tad above the recent all time highs

The trader defined their risk, but with a low probability outcome. The were likely leveraging an existing long, or taking a shot based on a rumor that an M&A deal would materialize over the next three months.

This morning The Wall Street Journal is reporting that Kraft Foods, and H.J. Heinz are to Merge, and KRFT shares are up 32% in the pre-market above $81. If the stock opens near these levels, I suspect we will see a block of 10,000 June 67.50 calls sold for almost 20x what the buyer paid only two weeks ago.

We followed up the initial post with some thoughts on long entries in the stock (Name That Trade – $KRFT: Whiz With) We highlighted the call buying and thought that coupled with the pullback to the prior technical breakout level (just above $60) that presented an attractive long entry. Although, there was a caveat given valuation:

The potential for restructuring and m&a as the new ceo sets a new course. Paying 18x expected earnings growth of 3% on expected sales growth of only 1% in 2015 seems a bit silly, with much of that premium likely related to the 3.6% dividend yield on the stock. And with the stock down 10% from last month’s highs, its easy to see how silly things were getting and how off-sides some investors have been.

We concluded that rather than buying the upside call strike (the one of the large print or similar) we would be more inclined to play for a higher probability trade that didn’t need such a large move.

We highlighted a strategy that had a much higher probability of success, but far lower potential payout if something crazy happened:

as one large player was looking out to June and buying the 67.50 calls, I might be inclined to use that strike as the short leg of a call spread. Gun to my head, this is the bullish trade I choose:

Hypothetical Trade: KRFT ($61) Buy June 62.50 / 67.50 call spread for 1.20

The trade idea that we offered would have initially risked more (that the large print) and this morning would have made much less. (It would have been profitable but c’mon, that other dude!)

So home-runs in options are fascinating. We all wish we bought those same options and were up 20x our money this morning. But let’s be honest here. Those sorts of trades are cheap for a reason. They’re extremely low probability. If you littered your trading portfolio over time being long 11% out of the money puts and calls, it would be a sure-fire way to consistently lose money.

However. Options pricing sometimes breaks down on tail risk. Like a bookie suddenly seeing a bet on a massive underdog and finding it almost impossible to locate the other side. The point spread can adjust, but only so much on an outlier bet. And that’s why whoever made that market and sold those KRFT calls is hurting this morning. That tail risk of being short those calls would be very difficult to hedge without putting on risk the other way (being long too many deltas as the stock went down, buying closer to the money calls and watching them decay, etc). For every home-run you see in the options market, remember there’s someone else that gave up that home run.