Distressed Volatility

Wow all of the banks are scrambling to merge to save themselves from this disaster!. This is even happening in the UK (Lloyds to buy HBOS in $50 billion deal). During the past few days I saw that HBOS Plc. lost about half its value at a point.

Traders bid up volatility on Morgan Stanley's options on Wednesday; sourced by the ISE Exchange, implied volatility in Morgan Stanley spiked up to 277.23%!! Today's stock price hit a low of $16.04 before getting bid up to $21.75 (-24%) at the close, which was probably due to the breaking news after the bell that there were talks between Wachovia and Morgan Stanley. It looks like the stock was initially bid up during after hours, but it's now off 75 cents to $21. The option market was very active, especially in the September 15 Puts where 55,855 contracts exchanged hands, the most out of all strikes. Call volume was also active with in- and out- of-the-money contracts losing more than 60% of their value with 47,795 contracts traded at the SEP 25 Calls, and 48,393 at the Sep 30 Calls. Calls actually outnumbered puts in the SEP month but puts more than doubled calls in October, so there are either trading strategies taking place or conflicting positions. The total put/call volume ratio still had a bearish bias at 1.43. With the most active contract, Sep 15 Puts, trading way over open interest and requiring the price to go below $13.65 to make a profit also added to the bearish bias. News about their widened CDS spreads also allowed the shorts to bring down the stock.

The cost to insure a $10 million block of Morgan Stanley debt for one year reached $2 million to $2.2 million upfront, plus the annual contract cost of $500,000, at one point Wednesday afternoon. Last week, Morgan Stanley swaps cost about $325,000 annually, with no upfront cost. Source

There were also articles regarding hedge fund clients leaving their prime brokerage..

Sept. 18 (Bloomberg) -- Morgan Stanley is losing hedge-fund clients who are concerned that a record drop in the New York- based investment bank's stock threatens its finances, investors and industry executives said. Hedge funds that account for less than 10 percent of Morgan Stanley's prime-brokerage balances this week withdrew their money or told the firm they planned to, according to a person with direct knowledge of the matter. Source

So will volatility eventually be sold and shorts squeezed due to the merger talk and the fact that Morgan Stanley has less exposure to the sub-prime disaster? Or are there bigger problems brewing within their prime-brokerage unit. We shall see what happens...

Chart Source: ISE.com