Perfect World: Is Chinese Small Cap Impropriety a Mirage or Reality?

Perfect World Co., Ltd. (PWRD) is an online game developer and operator in the People’s Republic of China. Perfect World develops online games based on its game engines and game development platforms.

The stock pop yesterday is actually quite the story – which is to say, it’s off of a significant drop Monday. Let’s start with the news that pushed the stock down $12.00 down to $8.81 (26.6%). This is a snippet from The Motley Fool:

"What: Shares of Chinese online game developer Perfect World were hoping for a do-over on Monday after plunging as much as 30% in intraday trading as rumors about fraud made the rounds.

So what: The plunge in Perfect World's shares is a perfect example of just how skittish investors are about small-cap Chinese stocks after some high-profile frauds were uncovered in the group. The "news" behind Perfect World's swoon hasn't been widely covered, but it appears that investors started hammering the sell button after a blog on Tianya -- a Chinese social-networking site -- alleged that there was an investigation going on at Perfect World.

The latest scuttlebutt notes that the blog post has been removed from Tianya and the company -- through a Wall Street research analyst -- has refuted the claims."

Source: Perfect World Shares Dropped: What You Need to Know, written by Matt Koppenheffer

Ah, the world of fraud and Chinese public companies. I recently posted an article on the future of China at large and in the past have asked a rather abrupt but, IMHO, fair question: Is China the largest fraud epidemic in the history of the world? Why China Will Collapse By This Summer.

In fairness to PWRD, the blog post purporting impropriety could be nothing more than.. well nothing more than nothing...

Let’s turn to the Charts Tab (6 months), below. The top portion is the stock price, the bottom is the vol (IV30™ - red vs HV20 - blue vs HV180 - pink).



Starting from 6 months ago, we can see the stock has dropped from the low 20’s, to single digits. The action Monday and then semi-rebound yesterday has seen the implied vol spike and then drop.

Let’s turn to the Skew Tab to examine the month-to-month and line-by-line vols.



Isolating the front two months, we can see that Jan lies above Feb, and the shapes are similar with a fairly large vol diff opening up the 9 strike (and below). Mar skew is a different animal with the 12 strike bid versus all surrounding strikes. In fact, the 12 strike calls are priced to higher vol than the 8 strike puts… Ok?...

The Feb/Mar 12 call spread sells ~14 vol points higher than it purchases (for example).

Finally, let’s turn to the Options Tab, for completeness.



We can see the monthly vols are priced to 85.60%, 79.47% and 80.73% for Jan, Feb and Mar, respectively. Of course, with the funky skew in Mar, the weighted average vol numbers don’t really tell the whole story.

I wrote about this one for TheStreet.com (OptionsProfits), so no specific trade analysis here. I will say that at this point it’s just absurdity in these stocks. Even if PWRD is doing nothing wrong – business as usual is still so risky due to stuff like that blog post, that any "certainty" is more likely a mirage than a reality. Ya know, or not?...

This is trade analysis, not a recommendation.