In a recent newsletter from Morristown, N.J.-based McMillan Analysis Corp. (www.optionstrategist.com), MAC president, Lawrence McMillan wrote an interesting editorial in rebuttal to Web articles dealing with a certain trade. Those authors can be called conspiracy theorists, at best; incompetents, at worst.

The articles in question appeared on Web sites such as www.optioninvestor.com and on higher-profile sites, such as www.thestreet.com — which, by the way, printed a retraction to its article.

The unfortunate result is that inexperienced option traders too often rely on advice from inexperienced “experts.” The trade in question, using Standard & Poor’s index options, serves as a giant exclamation point as to the folly of following blindly.

The trade involved the purchase of 60,000 S&P 500 (symbol: SPX) September 700 calls. The question that many option blogs and e-mails raised is why anyone would buy and sell such a large quantity of deeply in-the-money calls. The answer, posed by conspiracy theorists, is that it must be part of a plot to exploit profits from a market sell-off driven by some sort of terrorist attack, or a ruse used by a failing investment banker to raise cash.

The problem, as McMillan points out — although no other so-called expert seemed to notice — is that at the same time the 700 calls were traded, there was an equally large sale of SPX September 1700 puts. “To any seasoned option trader,” McMillan writes, “that should have been a clue that some sort of arbitrage was taking place. In fact, it was box arbitrage, or in [this] case, just half of a box.”

Before going any further, some explanation is required. A “box spread” is a pure risk-free arbitrage move designed to earn a rate of return that is generally greater than or equal to the risk-free rate for the time period in question. If you were looking to match the risk-free rate of return, you would attempt to earn it as, say, a capital gain.

It works like this: suppose the S&P 500 is trading at 1,480. Let’s assume for the moment, with two weeks to expiry, the SPX September 1700 puts are trading at US$220 (US$22,000 an option contract) while the SPX September 700 calls are trading at US$780 (US$78,000 an option contract). Both options are deeply in-the-money, trading at exactly their intrinsic value.

On the other side of this trade, let’s assume that the SPX 1700 calls and SPX September 700 puts are trading at US50¢ each. Both of these options are out-of-the-money, with little chance of having any value at expiration. That I have assigned any value to these options is merely to have a frame of reference to put the box spread into perspective.

A box spread can be implemented as either a credit or a debit spread. The debit version involves the purchase of the SPX September 700 calls and the SPX September 1700 puts for a total cost of US$1,000. Additionally, the arbitrageur would sell the SPX September 1700 calls and the SPX September 700 puts for a total net receipt of US$1. This trade has a total cost of US$999, but at the September expiration will be worth exactly the difference in the strike prices, which is US$1,000, no matter where the S&P 500 index settles at the time of the options’ expiration.

The credit version simply reverses the trade, resulting in a US$999 credit. At expiration, the credit box spread settles at US$1,000, which produces a US$1 loss. However, in this version, you earn interest on the US$999 credit between the time the credit is established and expiration. That return should equal the risk-free rate on money for that period of time.

The so-called “bin Laden trade” was nothing more than a two arbitrageurs crossing opposite sides of a box trade: one with the credit; one with the debit. Effectively, it was half a box because, as McMillan points out, neither arbitrageur probably felt it necessary to trade the “wings” (i.e., buy the 1700 calls or buy the 700 puts), believing that it would be virtually impossible for the market to move that dramatically in a period of two weeks.

With the trade in question, the box was trading at fair value (about US$997 near the end of August), with perhaps a slight edge to the sellers. Which is to say, why bother? In this case, because of the timing of the trade, it was probably a bet on the next move by the U.S. Federal Reserve Board.

@page_break@“If interest rates were to fall before the September expiration — that is, if the Fed stepped in with a rate cut before the Federal Open Market Committee meeting next week — the [box] buyers would suddenly see the advantage turn their way,” McMillan writes. In short, this was probably a bet by one side that the Fed would cut interest rates early, not a sinister bet by terrorists to profit from an attack.

In fairness, you don’t have to understand the intricate nature of various arbitrage strategies to question the logic of a conspiracy theory. In this example, the idea that someone was selling deeply in-the-money calls to profit from a terrorist event has to raise the question: why would anyone risk billions of dollars taking the other side of the trade?

The other theory making the rounds was that some troubled investment bank was using the credit box as a way to raise capital. But that, too, has no validity because you cannot take the capital out of the trade. It has to remain there to support the margin requirement. The only way this can be a risk-free trade is if traders believe the Options Clearing Corp. that stands behind it can settle; and the only way that can happen is if the OCC has the requisite margin to maintain the position.

What is most absurd about this exercise is the resulting investigation should a terrorist attack have actually occurred. How would you like to explain a box spread to the U.S. Department of Homeland Security?

From my perspective, the bottom line is that option traders need to be aware of the risks of reading more into a particular trade than is actually there.

Most important, you must never forget that many so-called “experts” find it easier to explain away anomalies with not so well thought out conspiracy theories than to spend the time examining the hard facts of the case. IE