SMH - Semiconductor Stock Options Cheap Despite CATALYSTS AHEAD!

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Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund managers and other active fund managers worldwide. Ryan Renicker, CFA

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SMH - Semiconductor Stock Options Cheap Despite CATALYSTS AHEAD!

  1. 1. March 3, 2006 Leveraging Lehman’s Research: Ryan Renicker, CFA 1.212.526.9425 SMH Options Cheap, Despite Catalysts Aheadryan.renicker@lehman.com We believe option market participants are pricing in very low risk expectations for the Semiconductor Devapriya Mallick HOLDRs Trust (SMH) and now is the time for investors to express their short-dated directional or vol 1.212.526.5429 dmallik@lehman.com views on the Semis by going long SMH options, as there are several potential catalysts that could either directly or indirectly impact SMHs realized volatility prior to March 17th expiration. For example, the TXN, XLNX and ALTR mid-quarter updates on 3/6. These 3 names alone account for over 25% of the SMH’s total weighting. In addition, other semiconductor-related companies not included in the SMH could also impact the group, as they have near-term events that could “spill over” into higher volatility in for the SMH in the next few weeks. Examples of these “spill over” catalysts include SMTC earnings on 3/6, FCS mid-qtr update on 3/7, NSM earnings on 3/9, TSM Feb. sales on 3/9 and KLIC mid-qtr update on 3/16. Bullish Short-Term Ideas: 1) Slightly less aggressive: long SMH Mar. ‘06 calls struck at $37.50 for about $1.45. 2) Relatively more aggressive: long SMH Mar. ’06 $40 strike calls for about $0.25. Bullish Longer-Term Idea: long SMH May 06 calls struck at $40 for about $1.20 (May implied vols also trading cheap vs. realized and SPX implied vol.) (Trade complements longer-term technical view of Lehman’s Chief Technical Analyst Jeff deGraaf.) Short-Term Vol Trade Idea: long SMH Mar. ’06 straddles or strangles, on a delta-hedged basis, to capture potential moves in SMH due to assortment of semiconductor-related events listed above.Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict ofinterest that could affect the objectivity of this report.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them,where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2LEHMAN to request a copy of this research.Investors should consider this report as only a single factor in making their investment decision.PLEASE SEE ANALYST(S) CERTIFICATION AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 3.
  2. 2. Equity Derivatives Strategy | SMH Options Cheap, Despite Catalysts Ahead Buy Cheap SMH Options for Directional or Vol View As illustrated in Figures 1 and 2 below, short-dated implied volatility on the Semiconductor HOLDRs Trust (SMH) is trading at very low levels, indicating that option market participants are pricing in very low risk expectations for this Semiconductor ETF in the near term, both relative to realized volatility and S&P 500 Index implied volatility. (SMH 3-month implied vols are also trading cheap. All prices in this note as of yesterday’s close.) We recommend investors having a short-term bullish stance on the Semis purchase calls on the SMH to take advantage of SMH’s relatively cheap implied volatility, particularly since there are several th potential catalysts for at least 3 of the SMH’s constituents before March 17 expiration, which could spark higher volatility in the SMH. For example: TXN mid-qtr update on 3/6. TXN has highest weight in SMH (nearly 19%). XLNX mid-qtr update on 3/6: XLNX’s weight in SMH about 4%. ALTR mid-qtr update on 3/6: ALTR weight in SMH about 3%. In addition, other semiconductor-related companies not included in the SMH could also impact the group, as several of these firms have near-term events that could “spill over” into higher volatility in the semiconductor space, including stocks in the SMH, and the SMH itself. For example: SMTC earnings on 3/6, FCS mid-qtr update on 3/7, NSM earnings on 3/9, TSM Feb. sales on 3/9, KLIC mid-qtr update on 3/16. Bullish Short-Term Trade Ideas: 1) long SMH Mar. ‘06 calls struck at $37.50 for about $1.45 (currently “in-the-money”) 2) long SMH Mar. ’06 $40 strike calls for about $0.25 (currently “out-of-the- money”) for a more aggressive bullish trade. Or, investors having a slightly longer-term bullish view on the semis – such as that of Lehman’s Chief Technical Analyst Jeff deGraaf – who likes this group from a longer-term technical perspective, could purchase SMH May ’06 calls struck at $40 for about $1.20. (May implied vols also trading cheap vs. 66-day realized and SPX 3-month implied vol.) Short-Term Vol Trade Idea: long SMH Mar. ’06 straddles or strangles on a delta-hedged basis to capture potential earnings-related and mid-quarter-updates-related stock price movements from the upcoming assortment of semiconductor-related events listed above.Figure 1: SMH 1-Month Implied Vol Cheap vs. Realized Vol Figure 2: SMH 1-M vs. SPX 1-M Implied Vol Approaching 2-Yr Low 17% 30% SMH 1-M Implied Vol vs. 22 Day Realized SMH 1-M Implied 22-D Realized Vol Spread 14% SMH - SPX 1-Month Implied Vol Spread Near 2 Year LOW 25% 11% SMH 1-M Implied Vol vs. SPX 1-M Implied Vol Appraching 2 Year LOW 8% 20% 5% 15% 2% -1% 10% -4% -7% 5% 4 5 05 06 4 5 6 4 5 4 4 5 5 4 5 05 06 4 5 6 4 5 4 4 5 5 -0 -0 -0 -0 -0 -0 -0 -0 l-0 -0 l-0 -0 -0 -0 -0 -0 -0 -0 -0 l-0 -0 l-0 n- n- n- n- ov ov ar ar ar ep ep ay ay ov ov Ju Ju ar ep ar ep ar ay ay Ju Ju Ja Ja Ja Ja M M M N N M M M M M S S N N M M S SSource: Lehman Brothers, OptionMetrics Source: Lehman Brothers, OptionMetrics March 3, 2006 2
  3. 3. Equity Derivatives Strategy | SMH Options Cheap, Despite Catalysts AheadAnalyst Certification:The respective research analysts responsible for the fundamental ratings hereby certify (1) that the views expressed in this research email accurately reflect ourpersonal views about any or all of the subject securities or issuers referred to in this email and (2) no part of our compensation was, is or will be directly or indirectlyrelated to the specific recommendations or views expressed in this email.I, Ryan Renicker, hereby certify (1) that the views expressed in this research email accurately reflect my personal views about any or all of the subject securities orissuers referred to in this email and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressedin this email.To the extent that any of the conclusions are based on a quantitative model, Lehman Brothers hereby certifies (1) that the views expressed in this research emailaccurately reflect the firms quantitative research model (2) no part of the firms compensation was, is or will be directly or indirectly related to the specificrecommendations or views expressed in this research report.Important DisclosuresLehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have aconflict of interest that could affect the objectivity of this email communication.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost tothem, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2-LEHMAN to request a copy ofthis research.Investors should consider this communication as only a single factor in making their investment decision.The analysts responsible for preparing this report have received compensation based upon various factors including the Firm’s total revenues, a portion of which isgenerated by investment banking activities.Stock price and ratings history charts along with other important disclosures are available on our disclosure website at www.lehman.com/disclosuresAnd may also be obtained by sending a written request to: LEHMAN BROTHERS CONTROL ROOM , 745 SEVENTH AVENUE, 19TH FLOOR NEW YORK, NY10019Options are not suitable for all investors and the risks of option trading should be weighed against the potential rewards.Supporting documents that form the basis of the recommendations are available on request. Please note that the trade ideas withinthis report in no way relate to the fundamental ratings applied to European stocks by Lehman Brothers Equity Research.Guide to Lehman Brothers Equity Research Rating SystemOur coverage analysts use a relative rating system in which they rate stocks as 1-Overweight, 2- Equal weight or 3-Underweight (see definitions below) relative to othercompanies covered by the analyst or a team of analysts that are deemed to be in the same industry sector (“the sector coverage universe”). To see a list of companies thatcomprise a particular sector coverage universe, please go to www.lehman.com/disclosures.In addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1-Positive, 2-Neutral or 3-Negative (see definitions below).A rating system using terms such as buy, hold and sell is not the equivalent of our rating system. Investors should carefully read the entire research report including thedefinitions of all ratings and not infer its contents from ratings alone.Stock Rating1-Overweight - The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.2-Equal weight - The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.3-Underweight - The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.RS-Rating Suspended - The rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstancesincluding when Lehman Brothers is acting in an advisory capacity on a merger or strategic transaction involving the company.Sector View1-Positive - sector coverage universe fundamentals are improving.2-Neutral - sector coverage universe fundamentals are steady, neither improving nor deteriorating.3-Negative - sector coverage universe fundamentals are deteriorating. March 3, 2006 3
  4. 4. Equity Derivatives Strategy | SMH Options Cheap, Despite Catalysts AheadDistribution of Ratings:Lehman Brothers Equity Research has 1859 companies under coverage.43% have been assigned a 1-Overweight rating which, for purposes of mandatory disclosures, is classified as a Buy rating, 35% of companies with this rating are investmentbanking clients of the Firm.40% have been assigned a 2-Equal weight rating which, for purposes of mandatory disclosures, is classified as a Hold rating, 6% of companies with this rating areinvestment banking clients of the Firm.17% have been assigned a 3-Underweight rating which, for purposes of mandatory disclosures, is classified as a Sell rating, 76% of companies with this rating areinvestment banking clients of the Firm.This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approved byLehman Brothers International (Europe), authorized and regulated by the Financial Services Authority, in connection with its distribution in the European EconomicArea. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australiaby Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. (“LBIS”). Where this material is distributed by LBIS, pleasenote that it is intended for general circulation only and the recommendations contained herein does not take into account the specific investment objectives, financialsituation or particular needs of any particular person. An investor should consult his Lehman Brothers’ representative regarding the suitability of the product and takeinto account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This materialis distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as anoffer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any mannerwithout the written permission of Lehman Brothers. With the exception of disclosures relating to Lehman Brothers, this research report is based on current publicinformation that Lehman Brothers considers reliable, but we make no representation that it is accurate or complete, and it should not be relied on as such. In the caseof any disclosure to the effect that Lehman Brothers Inc. or its affiliates beneficially own 1% or more of any class of common equity securities of the subject company,the computation of beneficial ownership of securities is based upon the methodology used to compute ownership under Section 13(d) of the United States SecuritiesExchange Act of 1934. In the case of any disclosure to the effect that Lehman Brothers Inc. and/or its affiliates hold a short position of at least 1% of the outstandingshare capital of a particular company, such disclosure relates solely to the ordinary share capital of the company. Accordingly, while such calculation representsLehman Brothers’ holdings net of any long position in the ordinary share capital of the company, such calculation excludes any rights or obligations that LehmanBrothers may otherwise have, or which may accrue in the future, with respect to such ordinary share capital. Similarly such calculation does not include any sharesheld or owned by Lehman Brothers where such shares are held under a wider agreement or arrangement (be it with a client or a counterparty) concerning the sharesof such company (e.g. prime broking and/or stock lending activity). Any such disclosure represents the position of Lehman Brothers as of the last business day of thecalendar month preceding the date of this report.This material is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of LehmanBrothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may notbe suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and theincome produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates,interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may beused to pay that income. © 2006 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in yourhome jurisdiction.Lehman Brothers policy for managing conflicts of interest in connection with investment research is available at www.lehman.com/researchconflictspolicy. Ratings,earnings per share forecasts and price targets contained in the Firms equity research reports covering U.S. companies are available atwww.lehman.com/disclosures.Complete disclosure information on companies covered by Lehman Brothers Equity Research is available at www.lehman.com/disclosures. March 3, 2006 4

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