Today’s “Know Your Options” isn’t actually specifically about options, but it’s about a concept that I hope will allow you to formulate more successful strategies for trading.

In general, the listed options that most traders are interested in are those that have an underlying asset that’s likely to move or is the subject of some significant uncertainty. Underlying and options prices that move are likely to produce substantial profits if your hypothesis is correct.

As an example, front month, at-the-money options in Proctor and Gamble (PG Quick QuotePG - Free Report) – the consumer products giant that rarely surprises investors – are currently trading at less than a 20% implied volatility. That’s even lower than the S&P 500 as a whole. Institutional investors use the options market to buy protection or create additional income in stocks like PG, but retail options speculators rarely pay those "boring" stocks much attention.

On the other hand, companies that are new to the public markets tend to move much more – and their options tend to trade at much higher implied volatilities. Lately, we’ve been seeing companies make their debuts on the public markets not only through traditional Initial Public Offerings, but also through Direct Offerings and mergers with Special Purpose Acquisition Companies.

The newly popular methods of bring a private company public can be less expensive and are almost always faster than a traditional IPO, but they also mean that investors don’t necessarily get the same volume and quality of information prior to trading. That uncertainty often brings volatility – creating more opportunities to make (and lose) money – but options traders should be aware of the differences.

The Traditional IPO

Over the past century, the most common way for a private company to become public and trade on the major US exchanges was through an Initial Public Offering - which involved disclosing internal financial data in a standardized form and engaging the services of one or more investment banking firms to underwrite the offering. Simply preparing the appropriate offering documents was often beyond the capabilities of many small companies who had previously concentrated all of their efforts on their own business.

Those underwriting firms made potential investors aware of the risks and potential of the soon-to-be-traded company. For a long time, that came in the form of a “road show” that involved brokers literally traveling the country and informing the salespeople who would be selling shares to the public to satisfy the requirement that they do their due-diligence before recommending an investment security to the public.

Based on the response from the road show, the underwriters gauged demand for the offering and set an initial trading price. In return for their efforts, the underwriters received either cash compensation, shares in the new company, or a combination of both.

Some popular IPOs have increased in value quickly, sometime doubling in price (or more) on the first day of trading. Despite the positive press they receive, that tends to be the exception rather than the rule. It’s in the best interests of the company as well as the underwriters for the offering to be priced at a level that public investors find fair.

The IPO method of going public gives prospective investor the most complete view of the financials and performance of a soon-to-be-public company.

Special Purpose Acquisition Corporations

The SPAC is a company that goes through the traditional IPO process before it has any measurable business activities. That makes the filing and underwriting process very simple. There aren’t any financials and the business description is something like, “using the proceeds to acquire one or more unspecified businesses.” It won’t surprise you that the nickname for a SPAC in the financial services industry is a “blank check” company. The investors have effectively granted management carte blanche to buy whatever they like.

Why would investors do that?

Because the rewards can be quite significant. Until recently, the shareholders of the SPAC would routinely retain up to 20% equity in the entities they acquired. That’s more than double traditional IPO underwriting fees. (In the recent SPAC boom, the share retained by the acquisition company is falling due to competition for the most desirable acquisition targets.)

Why would a private company accept dilution of 20% instead of 5-10% for an IPO?

The “good” reason: Speed. Acquisition by and already-listed SPAC is a fast way for a private company to have shares traded on a major exchange. In the case of “hot” industries like internet sports gambling or electric vehicle startups, getting to market quickly to have shares purchased by retail investors could mean quick appreciation well in excess of the additional dilution.

The “bad” reason: Reduced oversight. The SPAC filing process is relatively simple. Once approved, the new entity is free to buy almost anything that the directors approve. This doesn’t mean that there’s anything illegal or unsavory about SPACs, but investors need to be aware that for at least the first few quarters, they’re going to have much less insight and transparency into companies that list via a SPAC acquisition than they would from other public companies.

For options traders, less certainty generally means more price volatility in the underlying – and higher implied vols in the options.

The Direct Offering

Finally, there’s the “direct offering” in which the owners of a private company sell a portion of their ownership interest to the public without the assistance of underwriters. Eliminating underwriting commissions and fees reduces the dilutive effect, but also means that the owners are the major beneficiaries of the sale proceeds, rather than the company itself.

In some ways, the direct offering is inherently fair because the market determines a fair price rather than an underwriting firm. It’s all supply-and-demand.

This week, shares of the secretive technology firm Palantir (PLTR) began trading via direct offering. Though the company has yet to turn a profit, it was one of the lost highly anticipated offerings of 2020 and investors pushed the share price up to a market cap of $22 billion during the first day of trading.

The most unique part of the Palantir deal is a provision that grants the company’s three founders a class of shares that gives them almost 50% of the voting power – in perpetuity! Even if they sell their shares, they keep the votes.

Should that be  deal-breaker for investors? Not necessarily, but unconventional arrangements like that generally warrant extra scrutiny.

Options

So what does this all mean for options investors?

It means that traders should expect higher actual volatility and higher implied options volatility in the shares of companies that became public through non-conventional offerings and/or mergers.

There’s not much you can’t find out easily about Proctor and Gamble. The company’s finances are basically an open book and analyst projections tend to fall into a tight pattern – hence the low implied vols.

When there’s more significant uncertainty and the possibility of unpredictable events on the horizon, you should expect higher vols.

It doesn’t mean you shouldn’t trade these hot new companies. After all, movement in the underlying tends to be where big money is made in options. Conversely, big options premiums are where big income gets collected by option sellers when the underlying moves less than expected.

To get your piece of the action, you definitely need to understand the nature of the underlying securities of the options you trade. Newly fashionable offering methods make that a bit more difficult – but also presents an opportunity to profit from traders who don’t bother to figure it out.

-Dave

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