‘Lottery ticket’ call options saw big losses on Brexit

Emerging market call options dropped more than 80% after 'leave' vote

Traders rue ill-fated options bet

In the aftermath of the Brexit vote, a "lottery ticket" call option bet on emerging markets has caught the eye of traders – for all the wrong reasons.

Demand for out-of-the-money upside call options on the iShares MSCI Emerging Markets ETF (EEM) spiked fourfold on Thursday, June 23 – the day of the referendum. "We saw 275,000 July calls on the tape by 10am [Eastern Time] on Thursday morning. That's a lot of calls," says a portfolio manager at a US asset management firm in New York.

A New York-based equity strategist at a European bank puts the final volume of EEM call options traded on the day of the Brexit vote at 639,846 lots, versus 103,174 lots for puts – compared with a 20-day average of 155,324 lots for calls and 171,831 for puts. "People were more interested in buying the EEM via calls rather than holding delta," he says.

A lot represents options on 100 underlying shares.

The New York-based head of flow strategy at a second European bank attributes the surge in volume to one or two firms – probably hedge funds – trading in size. "Usually, what happens with this type of business is you have a couple of clients and that distorts the statistics," he says. "They come in and buy big size, and because these options don't trade that much, it increases average volume by five or six times."

The trades were likely a bet on Britain remaining in the European Union. "The best way to play that was through emerging market calls. If the vote goes to 'remain', the dollar sells off and the EEM rallies," says the portfolio manager.

However, when the markets awoke to a 'leave' vote on Friday, the calls plummeted in value, triggering a fire sale of the options.

The July 15 EEM call at the $35.5 strike, which was changing hands for 46 cents on Thursday, was selling for 6 cents on Friday – an 86.96% loss – with 152,528 lots traded at that price, according to Bloomberg data. EEM calls at the $36.5 strike fell from 18 cents to three cents over the two days – a loss of 83.33% – with 124,612 lots traded on Friday.

The EEM, which closed at $34.13 on the day of the referendum, fell to $32.9 after the vote.

"These guys were chasing a rally and it didn't come off," says the New York-based portfolio manager.

Nancy Davis, managing partner and chief investment officer at Quadratic Capital Management, a Connecticut-based hedge fund, says the calls were a "way upside lottery ticket" that failed to pay off.

"Probably somebody bought them on expectation of a 'remain' vote and a big emerging markets rip and sold them today at a loss," she said, speaking on June 24. "The $35.5 strikes went out at 45 cents [per call on Thursday] and somebody sold them today for a nickel [five cents]. The other big trade yesterday – the $36.5 strikes – were trading at 18 cents and the bulk of them trade for four cents or five cents today."

Mo Bajaj, director of ETF trading solutions at Wallach Beth Capital in New York, says there was a rush to exit positions after the referendum. "A lot of the gambling websites showed [the result] very heavily skewed to 'remain', so a lot of people thought this won't happen, they were nonchalant," he says. "All of a sudden, this news came out as a shock to everyone, the whole world, and those who were long the market just got run over. They sold out of positions because they needed to realise those losses. They didn't want to hold on to any long positions because they didn't want any more exposure to the downside."

Despite the magnitude of the plunge in EEM calls, the losses in dollar terms were fairly contained. Assuming all the calls at the $35.5 strikes sold on Friday were bought on Thursday, total losses would be just shy of $6 million, while the $36.5 strikes would have inflicted a little under $2 million worth of pain.

A New York-based portfolio manager at a second US hedge fund speculates the losses are likely concentrated in a mammoth firm that is able to absorb the pain.

"To make a $6 million bet on a lottery ticket like this, you probably manage more than $1 billion to begin with," he says. "From experience, when you take this type of bet just a few hours before a vote, it means you're likely massively exposed the other way and need some form of hedge in the case of a 'Bremain' tail."

A New York-based hedge fund investor says it is not unusual for large macro funds to allocate around 50 basis points of their notional assets to high risk, high return trades of this nature.

The torrent of EEM option sales in the days running up to the Brexit vote also drove creation and redemption activity in the underlying ETF.

Paul Weisbruch, vice-president of ETF/options sales and trading at Street One Financial in Pennsylvania, says $350 million entered the EEM via creations by authorised participants, "likely tied to the upside call buying" as option writers sought to hedge their short call positions.

The EEM itself traded more than 150 million shares on Friday, compared with an average daily volume of 67 million shares, Weisbruch adds.