Tuesday, April 15, 2008

Lehman Max Pain

Voltron says: If option hedging activity pushes LEH near $50, it'll be a golden opportunity to short more.

From Seeking Alpha:

The month of April has been quite intense for Lehman Brothers (LEH). The flood of bad news both from the financial and housing sectors has caused Lehman stock to fluctuate wildly - sometimes as much as 10% or more per day. With April options expiring on Friday, it is my belief that we will see the stock approach its max pain price - which is between $45 and $50 per share.

If you aren’t familiar with max pain, it is the theory that the price of a stock always settles around the point where the majority of the option buyers lose the most - hence max pain. At $50, the large majority of both put and call options will expire worthless.

In March, the month when Bear Stearns agreed to be sold to JP Morgan for a pittance, both Lehman and Merrill were widely believed to be the next targets for either bankruptcy or a take-under. Both stocks, however, ended within 5% of their max pain price targets, even though they faced serious issues. Now that the credit markets have eased a bit - with the intervention of the Fed allowing investment banks to use the discount window - I would not bet against the max pain price of $50 by Friday.

It’s possible, of course, that the price doesn’t quite approach $50 by Friday, as bad news is still coming out in droves. This is why I believe $45-$50 is a reasonable estimate. The only way this will not happen for Lehman is if they announce bankruptcy or a take-under before that time. Otherwise it April puts with a strike price at or below $45, and April calls with a strike price above $50, are going to expire worthless.

I still believe both Lehman and Merrill have a lot going against them, as I stated in an earlier investing blog post, and highly suggest shorting (either through puts or regular shorting) as soon as max pain is reached.

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