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No Rules in a Knife Fight

May 03, 2007

"Never bring a knife to a gunfight. Bring a gun. Preferably, bring at least two guns." -- Col. John Scott "Vapor" Walsh, USMC

Dear Fellow Options Trader,

Clearly, the act of bringing less-than-adequate weaponry to a military conflict can have disastrous consequences. Although there are a host of ways to introduce the concept of picking the wrong weapon for a particular fight, I love Col. Walsh's quote because he's a personal friend and because the concept behind it comes from one of the opening scenes from "Butch Cassidy and the Sundance Kid."

In that movie, "Butch" (Paul Newman) is called out by a member of his gang, "Harvey" (Ted Cassidy), a giant actor whom most of us remember as "Lurch" from the "Addams Family" television show.

Harvey demanded that Butch choose between guns and knives as a way of deciding who will become head of the gang. Butch picks neither, saying he doesn't want to shoot Harvey, at which point Harvey draws a huge knife and gets ready to carve Butch up into little pieces.

Butch whispers to his pal Sundance, "Listen, I don't mean to be a sore loser, but when it's done, if I'm dead, kill him," and walks over to Harvey.

Butch says to Harvey, "No, no, not yet. Not until me and Harvey get the rules straightened out." To which Harvey says his classic line, "Rules? In a knife fight? No rules!"

Butch's answer is to kick Harvey in the groin, dropping the giant to his knees as Butch says, "Well, if there ain't going to be any rules, let's get the fight started. Someone count. One, two, three -- go!"

EUREX BRINGS KNIFE TO GUNFIGHT

On Monday (April 30), the Deutsche Boerse known as the Eurex bid some $2.5 billion -$2.6 billion for the No. 2 U.S. options trading platform, the International Securities Exchange (ISE). While I'm sure the 43% premium over the ISE's closing price was a thrill to ISE shareholders, I'm afraid the Eurex is bringing a knife to a gunfight!

The vaunted Eurex has been a dismal failure at trying to take some of the futures business from the Chicago Mercantile Exchange and the Chicago Board of Trade. And, like the Nasdaq, it has made several attempts to buy the London Stock Exchange, but it has failed in those efforts as well.

So, the Eurex did what we all suspected it would do -- spend its treasure trove of cash to buy a U.S. derivatives exchange. But there are two major problems with its purchase of the ISE:

1) The Eurex is paying a stupefying 38 times the ISE's 2007 earnings.

2) It only gets the U.S. equity derivatives market, not the index market!

The second problem is significant because index options are big business for U.S. options exchanges. Through April 27, upward of 76.3 million index options changed hands, which is just shy of 1 million contracts trading per day! The ISE trades less than 5% of that figure, while the Chicago Board Option Exchange (CBOE) trades more than 86% of all U.S.-listed index options.

Clearly the reason the Eurex made a bid for the ISE rather than the CBOE was due to the latter's unresolved issues surrounding trading rights with the Chicago Board of Trade (CBOT).

This thorny issue has clouded the picture for years, as every full member of the CBOT has a trading right on the CBOE. The dispute comes down to whether that right is the same as equity, and this issue will be open until it's settled either by the courts or through an agreement between the exchanges.

When we plug the ISE valuation into our computer models and take into account that the CBOE has a 36% market share of total U.S. option volume against the ISE's 28%, you get a valuation for the CBOE somewhere north of $2.9 billion. Then, when you price in the proprietary index products (the S&P 500, S&P 100 and the Dow) -- that are the intellectual property of Standard & Poor's or the Dow Jones and that the CBOE is exclusively licensed to trade -- you get a relative valuation of $3.4 billion (or $3.6 million per seat multiplied by 930 seats).

The news of the Eurex bid for the ISE sent the CBOE seats, already trading at record levels, to fresh record highs. I show four seats traded on Monday, trading multiple times at $2.4 million. These seats were going for approximately $1.8 million at the beginning of this year, as a point of comparison.

ISE OPTION TRADES AHEAD OF EUREX BID

In early April, the Nasdaq Stock Market (NDAQ) was rumored to be in talks to acquire the Philadelphia Stock Exchange (PHLX), and all the publicly traded exchanges were thus put into play.

My friend Steven Sears, who writes "The Striking Price" for Barron's, was talking with me about our unusual activity reports and keeping an eye out for any of the exchanges that might hit our systems.

Surprisingly, we had strong readings on the NDAQ, even though it was only a rumored buyer. We rode the NDAQ June 32.50 Calls to some quick profits, but who would have known that the calls to watch were actually the ISE's? Who indeed, as someone appears to have had a look into the Wall Street crystal ball and took full advantage!

During the month of February, our computers showed 2,052 calls trading per day on the ISE. That number fell to 1,029 calls per day during the month of March and, as our computers showed, the first six days of April were not particularly interesting. But then on April 11, nearly 8,000 calls changed hands, which was eight times the average daily volume in March! Things calmed down during the two subsequent sessions, but then on April 16 and April 17, we also saw triple the March average changing hands in the May calls.



The primary purchases were the ISE May calls at the $50 and $55 strikes, which closed at 45 cents and 15 cents, respectively, on April 27. Those calls traded up to $17.60 and $12.80 on Monday. And, in both cases, the entire open interests were turned over!

DATE	CALLS TRADED
April 2	410
April 3	713
April 4	193
April 5	446
April 9	561
April 10	1,734
April 11	7,898
April 12	1,268
April 13	1,893
April 16	2,962
April 17	2,780
April 18	932
April 19	1,993
April 20	1,987

As with any situation in which we suspect some disreputable person(s) acted on privileged information, we refuse to believe the call buying on April 11, 16 and 17 is simply coincidental. My experience on Wall Street tells me there is no such thing as coincidence when it comes to situations like this.

With a total open interest of some 4,600 contracts at the May $50 and $55 call strikes, and an average profit of $15, I'd say there were $6.9 million reasons to think this was anything but coincidental!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader