Special Situation Trading

One of the advantages of working on a trading desk with diverse trading strategies is the opportunity to pick up trading ideas for a strategy or name that you don’t follow closely. This is one recent example of an interesting trade idea generated from the risk arbitrage group.

On May 10th Kinder Morgan (KMI) and El Paso Corporation (EP) announced a date for the completion of their merger of May 24th. This deal was holders of EP received either KMI stock or a combination of cash and stock. The particulars really were not of importance for this trade, what was important was knowing the risk arbs needed to short KMI stock versus the long EP they held. As demand for short KMI stock increased, the borrow rate became exceptionally high. If memory serves me correctly, the annual borrow rate was quoted around the high 50 percent.

As a result of the increase in borrow, the cost of the put options also increased. Most options software keep the interest rate constant and therefore an increase in borrow will be reflected as an increase in Implied Volatility. With KMI at ~$34 per share, the June 30 puts were trading with an implied volatility in the mid 50’s, realized 30 day vol was in the low 20’s. Additionally the stock had come off about $6 from it’s highs.

Typically a short volatility position should be delta neutral and in this case would require shorting KMI common against a short put position. The problem of course is the high borrow rate associated with KMI, it’s what caused the large increase in the put in the first place. There were a few options, do nothing and take the market risk, short KMI calls, or short a percentage of EP common.With 4 points or so and a specific date where the borrow should unwind, I took the second approach and shorted some KMI calls against the short puts creating a short strangle. The KMI calls were however trading at a relatively low implied vol and didn’t have as much delta as I would have liked so I remained with a delta long position. On May 10th I was quite comfortable with that exposure.

Turns out KMI basically went straight down, eventually closing on May 25th at 32.42 with a low of 31.60. The calls I was short did little to counter Mark to Market P&L on the short put options. Even with the headline of KMI being added to the S&P, there was little support for the stock. The bright side however volatility collapsed from 50 to around mid 30’s. I sold the puts for about ~.65 average and covered at .~30 average along with a small gain in the short calls. I’ll take the gain for being dead wrong on the delta. As an aside, the risk arbs following the situation more closely were able to sell those same puts for far higher, perhaps ~1.10 or so.

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~ by largecaptrader on May 26, 2012.

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