Citigroup Liquidity: On It’s Way or Here to Stay?

I’ve got some great questions since my last blog post on the Citigroup, Inc. ( C ) 1-for-10 reverse stock split. One recurring question is about C’s option liquidity. Citigroup options are among the most actively traded, high volume and consequently most liquid options on the exchange. Post-reverse split, will they still remain liquid?

At the center of this question is contract specification. Each standard equity option represents 100 shares of the underlying stock. In C, that means one call controls about $450 worth of Citigroup (with C at it’s current price of around $4.50/share). In options lingo, that’s $450 worth of notional value. For a trader to control $4,500 of notional value (still not a lot of corporate equity) traders need to trade just 10 contracts.

Once the C reverse split occurs, traders only need only to trade one option to control that same $4,500 of notional value. Many traders are speculating that because only 10 percent of the options currently traded will need to be traded to control the same notional value, we will see option volume in C drop by 90 percent.

Though there is something to this argument, I believe it is somewhat unfounded. I think C options should see some volume decrease, but it’s not likely to be the 90 percent drop off traders fear. And it’s not likely to be noticeable in observable liquidity for the typical trader. To understand this, consider why Citigroup may have decided upon the reverse split. In this trader’s humble opinion, the action likely stems from two things stated here in lay terms: street cred and getting rid of the riff-raff.

Many traders, especially pros (like hedge fund traders, money mangers and the likes) look down upon stocks trading under $10 as low-brow “penny stocks”. True enough, Citigroup has been around a while and gets its due respect on the Street. But that $4-and-change price tag is a reminder of the precipitous drop it took in recent past—a reminder that it can happen again. Citigroup does not want to be a penny stock.

And, novice traders who don’t really understand the market and are not well capitalized are probably more apt to trade a low-priced, name brand stock like Citigroup (at it’s current price level) for the worst reason of all: because it’s all they can afford. I would venture to say, that there is a lot of “riff-raff” trading Citigroup options (and stock), leading to higher-than-should-be volatility. They’re not trading value and assisting in the price-discovery process; they’re just creating noise.

If Citigroup gets rid of these two issues, they will have a higher-quality trading vehicle. And, the reverse split will take care of that. It will attract more trading capital: bigger money and smarter money. My speculation is that all this will lead to increased notional value being traded in C options. Not withstanding the point of being able to control 10 times the notional value with the soon-to-be newly-listed C options, the increase in notional-value trading that I anticipate should make up for some of that inherent lost volume.

Furthermore, in the short term, both “old” and “new” Citigroup options will trade in parallel. “Old” Citigroup options are the ones that exist now that will be adjusted to reflect the reverse split. “New” Citigroup options will be listed as new options following the merger. In the short-term, traders will roll out of old Citigroup options to new-Citigroup options, which will lead to increased volume. Further, arbitrageurs will be trading both to keep prices in line, supporting volume as well.

Overall, I believe there is not much concern for C option volume. Markets will likely be tight, deep, and highly liquid for traders just as they are now.

Dan Passarelli