Option players circle Merrill puts

By Doris Frankel

CHICAGO, Sept 12 (Reuters) - Some option investors in Merrill Lynch & Co Inc MER.N are betting the bank's shares could suffer significant losses between now and next Friday when September options go off the board, according to one analyst.

Merrill stock on Friday dropped nearly 9 percent to $17.69 in afternoon trade after hitting a new low of $16.90 as uncertainty about a deal to rescue struggling investment bank Lehman Brothers LEH.N hurt other financial stocks.

Put options, which convey the right to sell Merrill's shares at a given price and time, were the option's crowd favorite. A call conveys the right to buy the stock at a preset price and time.

During the first half of the day, about 395,000 puts traded in Merrill vs. 169,000 calls, four times the normal daily volume, data from option analytics firm Trade Alert show.

Fresh and heavy volume was seen in low strike September puts at strike prices $5, $7.50, $10, $12.50 and $15, all of which expire on Sept. 19.

One of Friday's top option trades was an order for 16,700 September $10 Merrill puts. The trade was part of a strategy called a butterfly spread where a strategist sold the September $10 put strike, bought 8,350 September $15 puts and 8,350 September $5 puts, said options strategist Frederic Ruffy at web site WhatsTrading.com.

The trade was entered this morning for a 80 cents a contract and has a potential payoff of $4.20 if Merrill Lynch shares close at $10 per share at Sept. 19 options expiration.

"Long story short, the profit range is roughly between $14.20 and $5.80 per share and indicates that this investor expects the stock to fall as least to $14.20 on or before expiration," Ruffy said.

A butterfly spread is a sophisticated trading strategy that involves four options and three strike prices.

In the case of a long butterfly put spread, one put is purchased at the highest strike, two puts are sold at the middle strike price and one put is bought at the lowest strike price.

It is a strategy with limited risk and has profit potential over a wide range on either side of the middle strike price.

The second biggest trade in Merrill this morning was a block of 15,000 January 2009 $7.50 puts for $1.50 a contract, Ruffy said.

That trade was part of a ratio spread where an investor bought 7,500 January $15 put strikes and sold twice as many January $7.50 puts. This trade was initiated for a net debit of $1.50 per spread and has a maximum payoff of $6 if Merrill Lynch shares fall to $7.50 by January options expiration, Ruffy said.

Investors often turn to put ratio spreads rather than buying outright puts because it reduces the upfront cash payment but it exposes them to big risk if the stock drops too much. (Reporting by Doris Frankel, Editing by Chizu Nomiyama)