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Striking Oil Via Options

September 06, 2006

"The secret of success is to get up early, work late and strike oil." -- J.D. Rockefeller

Dear Fellow Options Trader,

Mr. Rockefeller didn't become a success story without understanding that you need to strike a gusher to make serious money. You don't have to hit one every day, but you do need to make an occasional strike if that's the business you are in.

Veritas DGC (VTS) is in the business of helping oil companies find oil through the use of 3-D and even 4-D imaging systems, but it seems to us that someone might have had their own version of Veritas' imaging software, and they used it to sniff out Tuesday's merger between Veritas and Compagnie Generale de Geophysique!

HEATSEEKER JUMPS ON THE CASE

On Aug. 30, our HeatSeeker technology picked up on the very unusual buying of call options in Veritas, particularly at the VTS Oct 60 Call strike. And where HeatSeeker truly gives us an edge is that we were able to determine that the volume was meaningful because the buying was taking place on the offer price (a classic move on the part of smart money making big moves in advance of a major announcement) versus just a pop in trading volume, which could represent anything from covered writes to naked selling of calls (i.e., typically non-suspicious activity).

At 11:28 a.m. on Aug. 30 -- on absolutely no news -- trading of those October calls kicked into overdrive as the stock jumped more than 7.8%. Our phones were ringing off the hook as every buddy of ours on the Street looked for answers as to why volume had taken off. That surge in volume led to volatility in VTS leaping from normal levels of 43% up to 60%.

On that day alone, more than 9,400 calls traded, but again, the important part was that the vast majority of the calls were purchased on the offer and in big-block trades. Traders typically buy on the bid price and sell at the offer price, so when you see big buying at the offer (or sell) price, you know someone's up to no good -- and a lot of it!

A VIRTUAL GUSHER OF OPTIONS TRADING

During the entire month of July a total of 13,350 calls, or 635 contracts per day, traded in VTS. Action had picked up in August, and if we take out the 9,400 contracts that traded on Aug. 30, we show about 21,000 calls changing hands -- or 913 contracts per day. In other words, that day's volume was more than 10 times greater than the average daily volume.

The buying centered on both the VTS Oct 60 Calls, which were trading at about $5 per contract, and the VTS Sept 65 Calls, which were around $1.55 per contract. We deemed the activity in these calls as significant because it came without any news catalyst. In fact, the only event we were able to find was that the geophysical information provider had pulled out of this week's Lehman Brothers CEO Energy/Power Conference.

But on Tuesday (Sept. 5), France's Compagnie Generale de Geophysique, or CGG, announced that it had entered into a definitive merger agreement, giving VTS shareholders the choice of receiving 2.2501 CGG American Depositary Shares or $75 in cash! As you might expect, VTS opened near the upper end of that cash offer, trading up to $71.56 -- a $9.38 rally that put both the VTS Oct 60 Calls and VTS Sept 65 Calls deep in-the-money.



The Oct 60 Calls traded at $11, up $6 from the Aug. 30 entry, while the Sept 65 Calls tacked on $5.05, a mind-blowing 325% gain from the Aug. 30 entry price. One point that we should emphasize here is that most of the smart money that was in on these trades probably elected to exit via selling stock against their deep in-the-money calls. The reason why someone would want to sell stock against their calls is to generate a bigger return than from selling their calls outright. The answer why someone would do that is simple -- the options markets were displaying bid/ask spreads that were 30 cents wide, while the underlying stock (VTS) was trading on one or two penny wide markets.

In this case, these big-money players could choose between selling their calls for $6 ($11 offer price - $5 initial investment) or selling stock for an $11.56 gain ($71.56 market price - $60 strike price of the October calls). The calls held at the $60 strike give them the right to buy stock for $60 per share to cover that sale, which gives them a total win of $6.56 once you subtract the original investment.

It can be mind-boggling, all the activity happening in the options markets. This pre-merger activity is just one of the many things that pops up on our trading screens on any given day.

WHERE WILL OIL BE STRUCK NEXT?

When will the next wave of unusual options trading activity take place? It's always anyone's guess, as the activity heats up before something actually happens.

Looking at this week's scheduled events, we're sort of light on market-moving catalysts. But next week is a different story. I've got my eye on two heavyweights -- Texas Instruments (TXN) and Apple Computer (AAPL) -- with important, possibly stock-moving events.

TXN is due to report its mid-quarter update on chip sales after the bell on Sept. 11, and AAPL has yet another media event that might include a new iPod Nano on the 12th. We already have AAPL in our portfolio, and our turn to strike oil (so to speak) looks like it's coming next!

Good luck trading and remember -- pigs get fat, but hogs get slaughtered, so don't be a hog.


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader