Red Hat Put Sellers Provide Good Option Trading Example

04/01/2010 12:01 am EST


Beth Gaston Moon

, Schaeffer's Investment Research, Inc.

Red Hat Inc. (NYSE: RHT) saw a notable exodus of options traders at its April 27.50 put strike on Tuesday, as traders pulled their money out of the front-month option ahead of expiration two weeks from Friday. More than 20,000 contracts traded at this out-of-the-money strike yesterday, and open interest subsequently shrank from 20,269 yesterday to 7,211 this morning. This suggests that the majority of yesterday’s volume was initiated on the closing side.

Shortly before the closing bell, three large blocks (4,800, 7,200, and 6,951, adding up to nearly 19,000 contracts) hit the tape in rapid succession. The smallest block traded for 30 cents per share, while the two larger blocks changed hands at 25 cents per share (near the bid price in both cases, indicating they were sold). This is not much premium to collect, but perhaps the trader does not expect short-term downside in RHT. Unless RHT drops at least 5% before April 16, these puts will be out of the money and will expire worthless (which is a less desirable situation than closing them for 30 or 25 cents apiece).

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A put buyer can enjoy significant profits if the stock declines below the breakeven mark, but they would also put all of the premium paid at risk. Looking at open-interest history, it appears that these puts were purchased last Thursday for 40 cents each. Thursday was the day RHT tumbled almost 6% on a disappointing earnings outlook. Yesterday, the stock bounced higher, so perhaps these put buyers diagnosed that it was an opportune time to exit the trade and seek out better opportunities.

These investors who trade large amounts over a short period of time should be mindful of commissions, as these fees can eat away at profits, particularly when trading low-dollar options such as these out-of-the-money RHT puts.

By Beth Gaston Moon, contributor,

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