The Black-Scholes Model is Usually Correct...but
Consider the occasion when a corporation such as an Agency REIT issues more shares. This flood of new
stock at a lower price will create a temporary dip in the price of the stock. According to the Black-Scholes
model of options, this dip will be accompanied by a predictable dip in Call prices and increase in Put prices.
Whereas to some extent this is logical, let me consider the whole situation more carefully.
It is very human to develop a focus on a particular set of stocks and pay most of your attention to those
stocks. Any given human has only so much money to invest so the issuing of new stock at a discounted
price should dilute the real value of the stock by:
New Price = (Old price * Old Number of Shares + New Price * Newly Added Number of Shares)/New Total
Number of Shares
This would be logical, but the participants who focus on this stock may have to sell some of their current
holdings in order to afford this new offering. The net result is that the stock goes down in price for a few
days.
To provide an example. HTS had its stock priced at about $30.50 on January 3, 2011. It issued another 10
million shares to increase its then float of 46.1 million shares. If we apply the equation above, we find that
HTS issues 10 million new shares:
Added shares: 10,000,000 $28.75 $287,500,000
Old # shares: 46,100,000 $30.50 $1,406,050,000
New Total shares: 56,100,000 $30.1880 $1,693,550,000
Given our calculations, we suspect that the added shares will cause a temporary downward thrust in stock
prices as the market absorbs the new stock. In fact, on January 5th, the stock plunged to a price below the
offering price of the net stock.
We expect that the price of the stock will drift back up toward $30.18 or so. But if this is true, are the values
of the Call options correctly priced? If not, then they should be purchased for a profit. Here we will
purchase the following spread:
BOT 200 HTS $28 CAL @ $1.47 -$29,557.90
SLD 200 HTS $30 CAL @ $0.32 $6,241.99
If HTS goes to $30.18 as we expect it will, the long Calls will rise to 2.18 and the short calls will be at $0.18
for a $2.00 difference. Initial investment is $23,315.91 and we should be able to sell at $40,000.00 minus
commissions. This would be about $16,379 in profit.
We anticipate a profit of about 70% in 5 weeks and two days from the January 5th transaction.
Here is a five day chart showing how the information that there would be a secondary offering leaked out
and caused the stock to drop on Tuesday morning. It also shows how the stock dropped again when the
secondary announcement became official after the market closed on Tuesday. You may also note how the
volume of stock traded went up quite a bit on the opening on Tuesday and Wednesday. Those who had to
sell their old stock before the close of the market on Wednesday in order to get the cash to pay for the newer
stock shares are shown dumping their stock at the end of business on Wednesday. Note that as it went
down in price near the end of the day that the volume increased substantially.
After the close of the market on Wednesday, those shares which absolutely had to be sold that day are gone.
Thursday should be an up day.
Thursday opened up at 28.99 and hit 29.25 within the first 8 minutes.
Next
Consider the occasion when a corporation such as an Agency REIT issues more shares. This flood of new
stock at a lower price will create a temporary dip in the price of the stock. According to the Black-Scholes
model of options, this dip will be accompanied by a predictable dip in Call prices and increase in Put prices.
Whereas to some extent this is logical, let me consider the whole situation more carefully.
It is very human to develop a focus on a particular set of stocks and pay most of your attention to those
stocks. Any given human has only so much money to invest so the issuing of new stock at a discounted
price should dilute the real value of the stock by:
New Price = (Old price * Old Number of Shares + New Price * Newly Added Number of Shares)/New Total
Number of Shares
This would be logical, but the participants who focus on this stock may have to sell some of their current
holdings in order to afford this new offering. The net result is that the stock goes down in price for a few
days.
To provide an example. HTS had its stock priced at about $30.50 on January 3, 2011. It issued another 10
million shares to increase its then float of 46.1 million shares. If we apply the equation above, we find that
HTS issues 10 million new shares:
Added shares: 10,000,000 $28.75 $287,500,000
Old # shares: 46,100,000 $30.50 $1,406,050,000
New Total shares: 56,100,000 $30.1880 $1,693,550,000
Given our calculations, we suspect that the added shares will cause a temporary downward thrust in stock
prices as the market absorbs the new stock. In fact, on January 5th, the stock plunged to a price below the
offering price of the net stock.
We expect that the price of the stock will drift back up toward $30.18 or so. But if this is true, are the values
of the Call options correctly priced? If not, then they should be purchased for a profit. Here we will
purchase the following spread:
BOT 200 HTS $28 CAL @ $1.47 -$29,557.90
SLD 200 HTS $30 CAL @ $0.32 $6,241.99
If HTS goes to $30.18 as we expect it will, the long Calls will rise to 2.18 and the short calls will be at $0.18
for a $2.00 difference. Initial investment is $23,315.91 and we should be able to sell at $40,000.00 minus
commissions. This would be about $16,379 in profit.
We anticipate a profit of about 70% in 5 weeks and two days from the January 5th transaction.
Here is a five day chart showing how the information that there would be a secondary offering leaked out
and caused the stock to drop on Tuesday morning. It also shows how the stock dropped again when the
secondary announcement became official after the market closed on Tuesday. You may also note how the
volume of stock traded went up quite a bit on the opening on Tuesday and Wednesday. Those who had to
sell their old stock before the close of the market on Wednesday in order to get the cash to pay for the newer
stock shares are shown dumping their stock at the end of business on Wednesday. Note that as it went
down in price near the end of the day that the volume increased substantially.
After the close of the market on Wednesday, those shares which absolutely had to be sold that day are gone.
Thursday should be an up day.
Thursday opened up at 28.99 and hit 29.25 within the first 8 minutes.
Next
 | |  | |  | |  |
