Fear Still Infuses Lehman's Options

THE IMPLIED VOLATILITY of Lehman Brothers Holdings (ticker: LEH) options collapsed this morning in response to a second-quarter financial report that did not contain any surprises beyond the $2.8 billion loss announced last week.

In the absence of additional bad news, the implied volatility of Lehman's options traded to a low of about 73%, and edged higher to about 83%. These volatilities are markedly lower from the 120% or so levels on Friday, and are still almost twice as high as the financial sector.

Anyone watching Lehman's options during the company's conference call to discuss the second quarter would have seen options volatilities rising and flowing in response to management statements and stock analyst questions. Lehman's options volatilities may lose some sensitivity if Goldman Sachs (GS) and Morgan Stanley (MS) do not introduce negative surprises during their earnings reports that will be released Tuesday, and Wednesday, respectively.

The fear that is still priced into Lehman's options is a reminder that expensive options tend to remain expensive for longer than expected; the same is true for cheap options.


This chart shows Lehman's implied volatility and historic volatility during the past 30 days.

The conference call that Lehman hosted to discuss the second quarter seems to have done little to persuade investors to change their opinion on the stock. Some stock investors think Lehman's shares should rise since it trades at a discount to its $34 book value, and other investors do not.

The consensus in the options market appears to be that Lehman's stock is "dead money" and not likely to advance as the investment bank arguably sacrificed its earnings power to stabilize the firm against the deleterious effect of soured positions.


This chart shows Lehman's stock price since July 2007.

With Lehman's stock price up about 3% at almost $27 -- due most likely to short covering -- options trading suggests bearish speculators are readjusting bearish June put positions that would have increased in value if Lehman's stock plunged lower in response to the quarterly financial report. This is why there is so much trading volume in Lehman's June 15, 17.50, 20, and 22.50 puts, and then also in corresponding July options.

The July 30 calls are very active, but don't interpret that as a sign that investors expect the stock will soon trade above $30, or that anyone is establishing positions in Lehman that would increase in value if Goldman's earnings news lifts the sector. Lehman's July 30 call trading shows investors are readying for the stock to remain somewhat comatose. Investors have been selling July 30 calls almost since the stock market opened, effectively betting against the 7% advance that Lehman's stock logged when financial results were released.

The tell-tale options trade thus far is the buying activity in Lehman's October 25 puts. Almost 3,000 of these puts traded, suggesting that some bearish investors will lie in wait for Lehman's next quarterly financial report. They have bought these puts because they think Lehman's stock will decline.

Lehman's new management team did their best to allay investor concern during the conference call, and to defend their business model, but the message from the options market is that the fear ain't over till it's over.