The Striking Price Daily - Barrons.com

The Striking Price Daily - Barrons.com: "THURSDAY, JULY 10, 2008
THE STRIKING PRICE DAILY
Fear Factor Wall Street Style
By JON NAJARIAN | MORE ARTICLES BY AUTHOR
Profiting from rumormongering needs to be addressed.
http://online.barrons.com/article/SB121563152189940083.html?mod=b_hps_9_0001_b_online_exclusives_weekend

THURSDAY, JULY 10, 2008
THE STRIKING PRICE DAILY
Fear Factor Wall Street Style
By JON NAJARIAN | MORE ARTICLES BY AUTHOR
Profiting from rumormongering needs to be addressed.
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Editor's Note: Steven Sears, the regular writer of Striking Price Daily, is on vacation. Today's guest columnist is Jon Najarian, co-founder of optionMonster.com.

MANY OF YOU MAY be familiar with what Wall Street calls the old "pump and dump," whereby someone buys a stock, call option or future and then gets a rumor started about either a takeover, or scarcity of some commodity due to war, act of God, etc. In the pump phase the buyer accumulates a long position in that stock, index, future and then as the rumor circulates, the dump comes as the rumormonger exits his or her longs, selling into the feeding frenzy of the gullible followers.

One fundamental component of the pump and dump is that the rumor must be believable. The follow-along buyers need to believe the rumored buyer of Company A or a missile test by Israel could indeed be the catalyst for the bulls. The other components are central to the basics of trading activity since the beginning of time: Fear and Greed. In the case of the pump and dump, the party starting the rumor is counting on Greed, but the flip side of that is an even more nefarious and dangerous practice that is driving volumes today and that's Fear.

The Fear Factor version of the pump and dump is the polar opposite of the plain-vanilla buy calls, spread rumor, take profits. The Fear Factor version is accomplished when the rumormonger buys put options, which convey the right to sell the stock or index, then they spread the rumor through texting by IM and in chat rooms through their minions. When the market reacts, they sell out the puts, which jump dramatically in value as volatility surges and shares tumble.

Just this week we have two prime examples of the Fear Factor, as Freddie Mac (ticker: FRE) and Lehman Brothers Holdings (LEH) were targeted by the bears. In the case of Freddie the rumor was that a block of 25 million shares was "being shopped" to institutional investors. Since the three-month average daily turnover of Freddie shares was 13.6 million, a block of this size would clearly overwhelm the market. The rumor planter profited mightily as shares collapsed from $13 to $9.88 on Wednesday. The July 10 puts for Freddie (FRESB) traded from 20 cents to $4.00 in less than 24 hours, a staggering 20-fold return! The feeding frenzy for those puts was staggering, as over 72,000 contracts changed hands against a 30-day average trade of just 11,300 contracts.

The very next session (today) the rumormongers ran the Fear Factor on one of their favorite targets: Lehman. Step 1: In the first hour of trading the bears bought some 90,000 puts in Lehman, with the stock trading at $20. Step 2: The message boards start buzzing about Pimco, the world's largest bond fund, and how it was pulling business from Lehman. Step 3: The perpetrators liquidate (sell) their puts, and leave the follow-along traders holding the bag.

As we watched this transpire, we blogged, "Today we're hearing, perhaps started by the same hedge-fund group (that ran the Freddie rumor), that Pimco is pulling money from Lehman. That would create a run on Lehman and while the firm is obviously battered, but I seriously doubt that Bill Gross (Pimco founder) would issue a death sentence for Lehman, which a liquidity crisis would clearly do to the investment house. Tread carefully here folks, as a denial from Gross or Pimco co-CEOs William Thompson, or Mohamed El-Erain would result in a very fast bounce-back rally for Lehman."

As if we had written the script, a Pimco spokesman denied the rumor and shares of Lehman rallied from $15.98 to $18.20 over the next 15 minutes. The put trading also reversed, flipping from those 90,000 puts being bought on the offer, to another 100,000 puts sold on the bid! The July 12.50 puts (LYHSV) ran from 19 cents to $1.00, a fivefold return in one hour! The July 15 puts (LYHSC) ran from 39 cents to $1.82, a gain of 466%!

Last week in an interview with Charlie Rose, JPMorgan Chase (JPM) CEO Jamie Dimon addressed the fearmongering that contributed to the downfall of Bear Stearns when he said, "If I was the SEC, I'd find out who made the money (on the Bear Stearns meltdown) and I'd investigate like they do when they come after us all the time: e-mails, phone records -- you name it, and I'd find out."

I would echo what Mr. Dimon said, and if I am right and there are indeed people out there who are buying puts, rumormongering to get a panic started, and then stuffing their pockets with ill-gotten gains, those individuals should be prosecuted. A scan of the large buyers of puts on days when these rumors pummel stocks would very likely yield the firm or individual that started the very damaging and dangerous wheel in motion.

To those who say this is curtailing free speech, I say -- give me a break. If you have legitimate disagreement with financial statements a la Greenlight Capital's David Einhorn, then talk yourself silly. On the other hand if you are not expressing your doubts about the financial health of a company, but instead knowingly spreading a lie to profit from a market meltup or meltdown, then the SEC needs to do its job.

Comments: steven.sears@barrons.com