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| "USING DERIVATIVES TO DETECT MORE THAN THE CASUAL EYE MIGHT SEE" - Oct. 5, 2005 |
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Introduction
Friend and client, Warren West, is president of Greentree Brokerage Services, Inc., which he founded in 1998. This Philadelphia-based firm serves a client base comprised primarily of institutional investors, and its non-traditional approach to servicing its clients is designed to complement, not alter, their selection process.
In addition to being a registered broker-dealer, Greentree is a member of the NASD, SIPC, the Philadelphia Stock Exchange, and the American Bankers Association. One of the firm's more interesting background items, though, is its full certification by the Small Business Administration, the Commonwealth of Pennsylvania and the City of Philadelphia as a minority business enterprise.
Warren West's background is one of breadth and significant accomplishment. He has worked in the securities industry for 28 years. Over this period, he has been a member of the Philadelphia Stock Exchange, the American Stock Exchange, the Coffee Cocoa and Sugar Exchange, the New York Cotton Exchange, the New York Mercantile Exchange, and New York Stock Exchange Options Program.
But it is Warren's specific experience with equity-oriented derivatives that led me to ask him to write the short article that follows. In addition to agreeing to do so, he has graciously offered readers who are institutional investors the opportunity to sample a Greentree research staple. For further details on this very special offer, see my comments at the conclusion of the article, in the section entitled, "Receiving Greentree's Two-a-Day E-Mails."
--Doug Gillespie.
NOTE: I am immensely appreciative to Ms. Nancy Stevenson for her major contribution in helping coordinate and assemble this article. --DG.
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"USING DERIVATIVES TO DETECT MORE THAN THE CASUAL EYE MIGHT SEE"
Warren West
Greentree Brokerage Services, Inc.
October 5, 2005
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Whether one is fundamental or quantitative in their valuation methodology, there also is always some qualitative input involved. Of course, we all look at price action to maximize the value we hopefully have identified in our analysis. But in today’s markets, price behavior alone gives only a partial view of what we are really looking for.
Nearly 60% of all equity trading relates to some derivative transaction. This activity includes program trading, index and other arbitrage trading as well as options trading. These figures are published weekly in Barron’s, and as a recent edition indicated, "program trading" (as defined by the New York Stock Exchange) equaled 54.2%, 70.9%, and 51.6% of average daily NYSE volume during the weeks ended 9/9, 9/16 and 9/23, respectively.
Derivative transactions provide an excellent means to cover one’s tracks. This is significant because:
(1) Not all information is widely disseminated.
(2) There are always some players in possession of "new" information. These are the "insiders" we track.
Combined, these two observations underscore how investors who are focused solely on the price action of the underlying security are missing the opinion expressed by the majority of trading activity, which will encompass "insider" activity.
We are all familiar with "surprise" events that alter the fundamentals, to wit: takeover bids, increased or omitted dividends, unexpected earnings announcements, etc. Nearly all have been preceded by unusual activity in the derivative products. Greentree tracks the activity in derivative products and sends an e-mail twice daily to customers to apprise them of developments.
We certainly are not trying to make an argument for neglecting the fundamentals; you can’t make a good investment in a poorly run company. However, pure fundamental judgments may not always be enough. Enron, for instance, was considered a strong fundamental story by many analysts -- right up until the company declared bankruptcy!
Not every call or put purchase is indicative of insider activity. The operative word is "unusual." Therefore, it is crucial to know what constitutes unusual activity. It is a relative term. Every product has its own unique trading characteristics, and Greentree has developed the tools to assist institutional investors in their efforts to monitor the entire universe of related products.
There is a new breed of asset managers that is highly skilled in trading alternatives. The leverage an option affords makes them a favored tool for these non-traditional managers. A traditional belief is that if company insiders are selling company stock, then I don’t want to be long. Tradition would look at insider activity reports as one of the necessary qualitative components. Yet, insiders no longer are limited to straight buy and sell decisions when entering or exiting their holdings.
Reported sales of company stock by company insiders can have a compounding effect. They have the alternative to use the options market to hide their tracks by putting on a "collar." They can buy downside protection with the purchase of a put and sell an upside call to finance the put purchase. When either side of the collar is exercised, insiders have reduced their holdings while avoiding the reporting requirements of a straight sell. This is just one form of information that can be extracted from derivative activity.
Our analysis of derivative trading does not suggest a new way of managing assets; rather, it suggests ways in which appropriate analysis can enhance performance by watching for information the derivatives markets can give to managers.
The sell side has long used derivatives to mask its intentions and to offset the risk of facilitating trades for institutional clients. We believe the approach we employ can help institutional investors make better use of these instruments for themselves.
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Receiving Greentree's Two-a-Day E-Mails
As mentioned earlier in my "Introduction," Warren has agreed to let institutional investors reading this article sample the Greentree two-a-day tracking e-mails discussed in the article. To be placed on this list, or to learn more about Greentree's overall activities in this area, contact John Ballin at jballin1@verizon.net. Be sure to mention this article as the source of your interest. --Doug Gillespie.
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