In a recent newsletter from www.optionstrategist.com, Lawrence McMillan authored an interesting editorial. Something he rarely does.

The editorial was a rebuttal to web articles authored by those who at best, can be called conspiracy theorists, at worst, incompetents!

There articles in question appeared on Web sites like www.optioninvestor.com which presumably offers advice in the form of newsletters and commentary from option “experts.”

The problem, as so often happens, is that “expert” commentary finds its way onto other higher profile sites, like in the case, www.thestreet.com. Which, by the way, printed a retraction to the Bin Laden trade article.

The unfortunate results is that inexperienced option traders too often rely on advice from inexperienced experts. The trade in question, using S&P index options, serves as a giant exclamation point as to the folly of following blindly.

The trade involved the purchase of 60,000 S&P 500 (symbol SPX) September 700 calls. The question that many option blogs and e-mails raised is why anyone would buy and sell (for their to be a buyer, someone has to sell) such a large quantity of deep in-the-money calls. The answer, if you are a conspiracy theorist, is that it must be part of a plot to exploit profits from a market sell-off driven by some sort of terrorist attack, or a ruse used by a failing investment banker to raise cash.

The problem, as McMillan pointed out, but no other so-called expert seemed to notice, is that at the same time the 700 calls were traded, there was an equally large sale of SPX September 1700 puts. “To any seasoned option trader,” writes McMillan, “that should have been a clue that some sort of arbitrage was taking place. In fact, it was box arbitrage, or in [this] case, just half of a box.”

Before going further, some background. A box spread is a pure risk free arbitrage designed to earn a rate of return that is generally greater than or equal to the risk-free rate for the time period in question. If you were looking to match the risk free rate of return, you would attempt to earn it as say, a capital gain.

It works like this; suppose the SPX is trading at 1,480. Let’s assume for the moment, with two weeks to expiry, the SPX September 1700 puts are trading at 220, while the SPX September 700 calls are trading at 780. Both options are deep in-the-money trading at exactly their intrinsic value.

On the other side of this trade, let’s assume that the SPX 1700 calls and SPX Sept 700 puts are trading at 50 cents each. Both of these options are out-of-the-money with little chance of having any value at expiration. That I have assigned any value to these options is to merely have a frame of reference to put the box spread into perspective.

A box spread can be implemented as either a credit or a debit spread. The debit version involves the purchase of the SPX Sept 700 calls and the SPX Sept 1700 puts for a total cost of $1,000. Additionally the arbitrageur would sell the SPX Sept 1700 calls and the SPX Sept 700 puts for a total net receipt of $1.00. This trade has a total cost of $999, but at the September expiration will be worth exactly the difference in the strike prices, which is $1,000. No matter where the S&P 500 index settles at the September expiration.

The credit version simply reverses the trade resulting in a $999 credit. At expiration, the credit box spread settles at $1,000 which produces a $1.00 loss. However, in this version, you earn interest on the $999 credit, between the time the credit was established and expiration. That return should equal the risk free rate on money for that period of time.

The so-called Bin Laden trade was nothing more than a two arbitrageurs crossing opposite sides of a box trade; one with the credit, one with the debit. Effectively, it was half a box, because as McMillan points out, neither arbitrageur probably felt it necessary to trade the wings (i.e. buy the 1700 calls or buy the 700 puts), believing that it would be virtually impossible for the market to move that dramatically in a period of two weeks.

With the trade in question, the box was trading at fair value (about $997 near the end of August), with perhaps a slight edge to the sellers. Which is to say, why bother? In this case, because of the timing of the trade, it was most likely a bet on the next Fed move.

According to McMillan, “if interest rates were to fall before the September expiration – that is, if the Fed stepped in with a rate cut before the FOMC meeting next week – the [box] buyers would suddenly see the advantage turn their way.” In short, this was most likely a bet by one side that the US Federal Reserve would cut interest rates early, not a sinister bet by terrorists to profit from an attack.

In fairness, you don’t have to understand the intricate nature of various arbitrage strategies, to question the logic of a conspiracy theory. In this example, the idea was that someone was selling deep in-the-money calls to profit from a terrorist event has to raise the question; why would anyone risk billions of dollars taking the other side of the trade?

The other theory making the rounds was that some troubled investment bank was using the credit box as a way to raise capital. But that too has no validity, because you cannot take the capital out of the trade. It has to remain there to support the margin requirement. The only way this can be a risk free trade is if traders believe the Options Clearing Corporation (OCC) that stands behind it, can settle. And the only way that can happen, is if the OCC has the requisite margin to maintain the position.

What is most absurd about this exercise, is the resulting investigation should a terrorist attack have actually occurred. How would you like to explain a box spread to the US Homeland security?

There was one other trade that made the rounds and McMillan commented on that as well. This trade occurred on August 22nd, where 55,000 SPX 800 and 850 strike puts were traded. At the time the S&P 500 composite index was at 1,464.

If you look at these trades in a vacuum you might conclude this was also a “Bin Laden” trade. In reality, writes McMillan, “it was much more interesting.” Essentially, “this was an attempt by some traders to influence the price of the VIX (CBOE Volatility Index) settlement that morning. The way that VIX is settled has to do with trades in various September options on that date (or the bid-asked spread if there is no trade).” In this case, two questionable characters crossed the 800 strike puts at 30 cents, for an implied volatility of 79.67%.

Because of how the CBOE settles the VIX, that has the affect of inflating the settlement value. But, as McMillan points out, “the CBOE canceled that trade and re-priced the trade at a nickel (67% implied volatility). If you recall, there was a long time before the settlement price of 25.05 for VIX was posted that day. That’s because the CBOE was hunting these trades down and putting them in line with the market.” Even with that scrutiny the VIX settled 1.50 points higher on the morning settlement.

From my perspective, the bottom line is that option traders need to be aware of the risks of reading more into a particular trade then is actually there. Most importantly, never forget that many so-called experts find it easier to explain away anomalies with not-so-well-thought-out conspiracy theories, rather then spend the time examining the hard facts of the case.