Frankenstein

14 thoughts on “Frankenstein”

1. Can anyone help me understand this: do (and how do) dealers set the premium for an option? If dealers perceive risk to themselves from options transactions, can they simply jack up premiums to compensate?

   1. Do you think it’s so simple that a couple of paragraphs will explain it to you?

      1. A couple of well written paragraphs are normally enough to explain the gist, if not the detail, of most things.

      2. While the Black-Scholes model was the first to try to help determine “efficient” intrinsic values for options, before its publication the market was very different, but instructive. While a finance doctoral student in the late 1960s I shared an office with a brilliant 19 year-old PhD student who was an expert in options. In those days options had no organized market, no exchange trading. Options were transacted through facilitating broker-dealers who literally put buyers and sellers together on the telephone where give-and-take auctions would take place until the parties agreed to a price. My classmate would start getting calls when the NYSE market opened and stocks started to trade, something that would last until the Pacific Coast Exchange closed. Some broker would call him and say something like, I’ve got a guy who wants a put for 600 shares of IBM to expire on such and such a date. Will you write it? How much do you want for the put? My friend would make a few calculations and say I’ll write the put for $xxx. The broker would say something like, I’ll get back to you. Fifteen minutes later the broker calls back with an acceptance or a counter-offer. If the deal gets done, money changes hands, the transaction is recorded and funds held in the proper account. That’s how premiums used to be set. They were whatever the market needed to clear the transaction. This classmate was very good at this, btw. He essentially started at zero in high school and when I graduated he was nearly done with school and had a mid- six figure net worth and a PhD. His dissertation was the first comprehensive study of the options market. Now the market is ordered and bid/ask prices are open for all to see. The market is centralized, transactions take place on exchanges and deliveries and exercises controlled by regulations. Still the market sets the price.

   2. Options pricing is just like any other pricing. The premium goes up when few are willing to sell options and many want to buy them. Sure, Black-Scholes and other models serve as guidelines, but ultimately the price is set by buyers and sellers. Search for “volatility smile curve” to learn more.

      Yes, what you say is true. When the volatility of the underlying is high, you’ll see liquidity dry up in the puts and calls because the options sellers don’t want to get burnt. Lower volatility tends to drive the risk premium up: only those who really want the insurance are willing to chase the widening spread.

2. “SoftBank’s aggressive buying program entailed spending some $4 billion on upside premium, with Masayoshi Son taking on notional exposure of around $30 billion in the process.”

   I’m a little confused by this in the reporting, as I believe it has also been reported that the buying was in deep OTM options. Right now, for example, AAPL is trading 120ish, and for the same leverage as described above the option purchased would be $16. An option costing $16 for AAPL, for say Oct 23, 7 weeks out, would be at about the 100 strike, or $10 in the money.

   1. The reason I bring this up is it seems to me that Softbanks buying, if the description of the program in the reporting is correct, was not likely in deep OTM options. A ratio of 7.5-1 premium suggests in the money options, or modestly out of the money options, depending on the volatility of the underlying. Perhaps the Softbank buying was in options relatively close to the price of the underlying, and its effect was amplified by retail buying deep OTM options.

      If so, retail once again was the beneficiary of what larger buyers were doing. At least until Thursday.

      1. Exposure equals spot price times delta (value change of the derivative for every dollar change of the underlying). Options close to the money have a delta of around 0.5.

         October 23 AAPL 140 calls have a delta of 0.25 and a cost of about $4. With spot at $120, the leverage is $120 * 0.25 / $4 = 7.5 to 1.

         This agrees with the reporting.

         1. Thanks Manuel for explaining this. I greatly appreciate it!

            Greg

   2. It would be silly for SB to buy options with two-three month expiration date.
      S130 calls for June 2021 cost exactly 16.
      And one-two month ago $130 was way OTM.

3. I’m interested in game planning the unwind. This does not seem like a viable long term strategy and is merely playing on current market psychology (markets can’t go down because of Uncle Jerome).

   I would expect a black swan would be the catalyst. Then a lot of forced selling. SB and Robinhooders take a bath. But what is the risk? Are we talking about hitting down side circuit breakers for multiple days in a row? What’s the amplitude of the downside.

4. Would not the same strategy work in reverse/ short side?

5. A Greek that springs to mind is Lamda, defined as the ratio of leverage the option will provide as the price of the underlying asset changes by one percent. The sensitivity increases with price and volatility. So as price goes up at the same time that volatility is increasing, the delta leverage explodes forcing those short to rebalance and buy more an more stock. The Reddit strategy is real. I still wonder if the Whale rebalanced, although it seems to be the case that this did not happen according to most reports.

6. H-Man , good note. VIX = Frankenstein