Merrill option trading before write-down turns heads

CHICAGO (Reuters) - Bearish options activity in Merrill Lynch & Co MER.N just hours before the investment bank revealed another round of losses and a huge share offering turned some heads on Wall Street this week.

But option analysts said they doubted the jump in put option volume was tied to a news leak, since the posture of the market on Merrill has been very bearish since the top U.S. broker first revealed heavy credit market losses months ago.

"I don't think the news was leaked," said Michael Schwartz, chief options strategist at Oppenheimer & Co Inc.

"I think it caught the Street totally by surprise. Merrill has been on Oppenheimer's underperform list. The volatility in its stock and options has been extremely high and some investors may have been selling put premium because they were expensive," Schwartz added.

U.S. Securities and Exchange Commission officials said they continually probe any abnormal trading activity, but would not comment on any potential investigations into the option trading in Merrill Lynch.

Merrill Lynch said after the bell on Monday it would take a $5.7 billion third-quarter write-down as it unloads risky debt and also raise $8.55 billion by selling new stock.

Before the announcement, Merrill shares had sunk $3.19 to $24.33, down 11.6 percent in New York Stock Exchange trading. The stock was little changed at $24.35 after-hours on Monday, but rebounded $1.92 on Tuesday, up about 8 percent, to end at $26.25. For full story, please see <ID:nN29358804>

On Monday, 239,992 option contracts traded in Merrill, compared with the average daily turnover of 200,735 contracts in July, according to the Options Clearing Corp.

Put options -- allowing owners to sell Merrill shares at a preset price within a specified time period -- outnumbered call options by 2 to 1. A call conveys the right to buy the stock at a given price and time.

"It is always possible that the news was leaked out, but this is one time when insider traders would have come out on the wrong side of the trade," said Randy Frederick, director of derivatives at Charles Schwab & Co.

Those who bought puts on Monday would not have made money on Tuesday unless they sold them in the first five minutes of trade on Tuesday, Frederick noted.

The value of a put premium goes up when the share price goes down, and Merrill shares rallied on Tuesday.

"There's been no shortage of potential volatility fueling rumors surrounding Merrill in recent days," said Interactive Brokers Group options analyst Rebecca Engmann Darst.

But others said the SEC's current crackdown by "naked short selling" the stock in Merrill and other troubled investment banks may have contributed to the heavier use of put options.

"No question about it: put volume has increased dramatically since Merrill appeared on the no naked shorts list last Monday," Frederick said.

The SEC emergency rule to curb abusive short selling in 19 major financial stocks went into effect on July 21. It requires an investor to borrow shares before executing a short sale and to deliver the securities by its settlement date.

"Was there a lot of puts being bought in Merrill before the news? Absolutely," said Joe Kinahan, chief derivatives strategist at online brokerage thinkorswim.com.

"Many of the puts purchased on Monday were bought as protection for long stock," he said, referring to those holders of Merrill shares who wanted a hedge in case the shares fell.

"There does not appear to be evidence of any inside information, but rather people protecting stock because of fear of the unknown. Nobody knew what to make of this deal," he said."

(Reporting by Doris Frankel; editing by Peter Bohan, Gary Crosse)