20 Things to Do Before You Ask for a Price (Part 3)

[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange, where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry.

[00:00:19] Folks, it's time to continue our journey to 20 Things to Do Before You Ask for a Price.

[00:00:25] A reminder, you are here because you A, love my mellifluous voice, B, have 15 minutes to kill on the treadmill,

[00:00:33] or C, you are craving some insights on understanding context for an option trade before you embark on a Thanksgiving feast.

[00:00:41] Let's add D, all of the above, shall we?

[00:00:44] To review, 20 Things is a to-do list I developed more than two decades ago while running a derivative sales team.

[00:00:51] The desk committed a substantial amount of capital in pursuit of business, which made it easy to win trades, but also easy to lose money in the process of winning those trades.

[00:01:01] 20 Things was about playing defense and offense simultaneously by requiring the salesperson to be an active part of the price discovery process.

[00:01:10] While the trader would ultimately make the price and bear the risk, the salesperson, through 20 Things, could be a valuable part of the process.

[00:01:18] The result? Better risk-taking and a more sustainable business.

[00:01:21] After all, unlike an actual casino, a derivatives casino is short information asymmetry.

[00:01:28] The actual casino? What a business.

[00:01:31] Create a series of games that folks simply cannot win at, but are compelled to try anyway.

[00:01:36] Throw some booze, a generous helping of food, and the occasional show at them, and they are even more likely to try their luck.

[00:01:43] In the markets casino, especially the derivatives component of it, the sell side gets the commish, but in the process could get wrecked being on the wrong side of information asymmetry.

[00:01:55] Sure, Phil Ivey may have some information that puts the casino at risk, but that's a rarity.

[00:02:01] In the markets casino, the customer needs to be embraced and managed all at once.

[00:02:06] The phone rings and the client has a trade in mind.

[00:02:08] It's a good bet he or she has spent some time on said trade before proposing it to you.

[00:02:14] It's also a good bet that you, while intelligent, handsome, and an all-around good person, are not the client's only call.

[00:02:21] Your team is short the winner's curse.

[00:02:23] Hey, you were the best offer. Your trader's amazing. We've got to trade.

[00:02:29] How much did I win by?

[00:02:31] A frequent outcome of the winner's curse is buyer's remorse.

[00:02:34] It reminds me of a scene in War Dogs.

[00:02:36] No, not the one where Ephraim, played by Jonah Hill, has a good time trying to buy weed, but that's a fine scene, too.

[00:02:42] It's where Ephraim and David learned that they were the best price by an absolute mile in securing a Defense Department procurement contract.

[00:02:51] Now, that is buyer's remorse.

[00:02:53] Okay, let's get into it.

[00:02:54] As my main man, Logan Roy, would say, it's time for things 11 through 15.

[00:02:59] And as luck would have it, we've got some good ones here that I think speak to the nuances of each order that comes your way as a sales trader.

[00:03:07] Remember, by having context on the client, on the risk environment, on the stock, and then also having a real appreciation for risk,

[00:03:15] the sales trader can be a meaningful part of getting the trade done.

[00:03:19] Thing 11 is to quickly check to see if the stock is part of some corporate action.

[00:03:24] Cross out VIX and any index or ETF option, thing 11 doesn't apply.

[00:03:28] We're looking for names that might be part of some deal.

[00:03:32] You can quickly use the Bloomberg CACS function to check.

[00:03:36] Why do we care?

[00:03:38] Names involved in some risk-garb situation can take on unique and often difficult-to-hedge distributions.

[00:03:43] A professor back from my University of Chicago days, Mark Mitchell, authored one of the earliest pieces on the risk characteristics of risk-garb,

[00:03:52] essentially illustrating that the position was similar to that of an out-of-the-money put option.

[00:03:57] The piece, Characteristics of Risk and Return in Risk-garb, was published in the Journal of Finance in 2001.

[00:04:04] Think about it.

[00:04:05] Stock A proposes to buy stock B for a share of stock A with an expected close date by year end.

[00:04:11] Stock B surges on the announcement.

[00:04:14] Time passes and there are no regulatory issues still to clear.

[00:04:18] The stocks trade in correlated fashion.

[00:04:20] The market has a strong view that the deal will go through.

[00:04:23] Easy peasy.

[00:04:24] With a month left, the market might simply price this as the discounted present value of the share price of the acquirer, plus some small spread.

[00:04:34] That spread ought to be thought of as some compensation for bearing the risk that what appeared money good actually might not be.

[00:04:41] To the extent that the target had rallied sharply on the announcement of the deal, there could be some pain in the reversal.

[00:04:48] A security that pays a little most all of the time, but occasionally suffers substantial losses, looks and acts like an out-of-the-money put option.

[00:04:57] Risk-garb is a business in which information asymmetry can be especially high.

[00:05:01] Your client may or may not be up to something in asking for puts on the target.

[00:05:06] It could simply be prudent risk management with no information edge.

[00:05:10] But even then, risk-garb trades that unwind do so in a way that being short puts with a delta hedge just ain't going to hold up.

[00:05:18] The move lower will be too violent.

[00:05:20] I'm recalling the failure of the Tell Lab Sienna deal in September of 1998, which sent Sienna lower by 30% and compounded the losses for an already teetering LTCM.

[00:05:32] There's another way in which corporate actions are tricky, and you just have to let your trader know that you know pricing this stuff is difficult.

[00:05:40] Some deals are consummated with a cash takeover in mind.

[00:05:43] That company called X, formerly known as Twitter, is an example.

[00:05:47] The vol of a cash asset, at least in theory, is zero.

[00:05:51] With respect to the Twitter deal, one could infer the implied probability that a deal was going to get done by looking at the options market and seeing the extent to which there was time value.

[00:06:01] One might also follow the tweets of Elon to get an idea.

[00:06:04] Here's a war story for you.

[00:06:06] A derivative salesperson is looking to pitch cheap vol ideas to a giant and incredibly well-respected and sophisticated multi-strat hedge fund.

[00:06:14] Look at this vol.

[00:06:15] It's seven.

[00:06:16] I can't find anything like it.

[00:06:18] And the realized is 20.

[00:06:21] The salesperson eagerly explains seeing both opportunity and commission.

[00:06:26] The hedge fund, not familiar with the name, promises to do work on the idea.

[00:06:30] A few days later, the glorious pricing, still the same, the chief portfolio manager comes back with a sizable order to buy vol.

[00:06:39] The trade completed.

[00:06:41] The commission booked.

[00:06:42] What's left is for the client either to realize the option's cheapness by trading the delta hedge or, even better, for the market to catch on and bid for these outrageously underpriced options that were somehow overlooked.

[00:06:54] A day later, the situation is indeed resolved.

[00:06:57] The client has found out that the underlying in question is subject to a cash takeover.

[00:07:03] It hasn't moved in weeks, but for the initial surge on announcement day.

[00:07:08] You told me to buy vol on a cash asset.

[00:07:10] Get me out of this now.

[00:07:13] And that, folks, is called moving on.

[00:07:17] Speaking of moving on, let's move on to thing number 12.

[00:07:20] This is a favorite and really could be an entire podcast.

[00:07:24] Thing 12 is simply to evaluate the vol.

[00:07:27] Oh, is that all?

[00:07:28] It's my way of telling the salesperson that you are not merely an intermediary between client and trader.

[00:07:34] You have to have a considered view, even if ultimately you are the only one of the three of you that actually doesn't decide to trade.

[00:07:43] Evaluate the vol means doing a number of things in a hurry.

[00:07:46] First, run HVG, historical volatility graph, and make sure you get a few different date windows.

[00:07:53] I like six-month, three-month, two-month, and two-week.

[00:07:56] Look for patterns.

[00:07:57] Is vol decelerating or accelerating?

[00:08:00] Is the very short-dated vol much higher or lower than the others?

[00:08:04] Markets can price vol off a very recent experience.

[00:08:07] If you see short-dated vol just hit the floor and your client is an overrider,

[00:08:12] you should take note that some unwanted supply of options may soon be coming your way.

[00:08:17] Next, run GV.

[00:08:18] This will allow you to look at implied vol and get a sense as to where it's trading relative to its history.

[00:08:24] Is it in a very low or high percentile?

[00:08:27] Next, how does that implied compare to realized?

[00:08:31] Us derivative geeks like to call this carry.

[00:08:34] The GV screen will allow you to compare implied to realized and see where that stacks up on a percentile basis.

[00:08:40] This kind of comparison is always driving through the rearview mirror.

[00:08:44] That is, take rich, cheap comparisons on this basis with a grain of salt.

[00:08:50] As we discussed earlier with the risk-garb name taken out for cash,

[00:08:54] the implied was really low and the realized quite high, but only because of one day.

[00:08:59] A consideration when looking at realized vol is the notion of, quote,

[00:09:03] trimming the series to eliminate giant, conceivably one-off moves that may inflate the level but shouldn't be counted on.

[00:09:10] If you're an old-timer like me, that exercise likely forces you into good old Microsoft Excel.

[00:09:16] Moving on to thing number 13, and that is, what does the strike skew look like?

[00:09:21] This is a good one.

[00:09:23] When we talk about option pricing, we often invoke the notion of a, quote, vol surface.

[00:09:28] That is, the matrix of strike prices and expirations in the individual vols assigned to each element in the matrix.

[00:09:35] Black-Scholes would have us be indifferent to both strike and expiry when pricing options.

[00:09:40] The market has said, we like Black-Scholes, but we'll take it from here.

[00:09:44] The strike skew illustrates the implied vol for each strike price for a given expiration.

[00:09:49] In markets, put skew is generally the law of the land,

[00:09:53] leaving the implied vol of out-of-the-money puts higher than that of out-of-the-money calls.

[00:09:58] Markets tend to move down faster than they move up,

[00:10:01] and there's more demand to protect wealth via downside puts.

[00:10:04] There are surely notable exceptions, including underlyings like GLD, USO, IBIT, and everyone's new favorite, MSTR.

[00:10:14] Get a quick appreciation for the put skew via the OVDV space skew screen.

[00:10:20] How does it look relative to how it looked a month ago?

[00:10:22] Is the skew flat or steep?

[00:10:24] That is, is the vol differential for the downside put higher or lower than it normally is?

[00:10:29] There are instances when skew absolutely blows out.

[00:10:33] General Motors, before bankruptcy that is, sported a gigantic skew,

[00:10:37] very related to its unsustainable debt stack.

[00:10:40] Not so much these days.

[00:10:42] The three-month 25 Delta put-call skew is a mere 1.5 vols in the ninth percentile over the last decade.

[00:10:49] This is a broader topic to discuss, but skews are generally flatter than they used to be.

[00:10:55] Up crashes like that featured in the meme Jan 21 episode and a market that has consistently punished investors

[00:11:02] for paying up for OTM put premium have likely played a role.

[00:11:06] The big picture on thing 13 is that having a view on the skew,

[00:11:10] just like having a view on the vol, is valuable and might enable you to help your trader think through the trade and the risk it brings.

[00:11:17] Okay, thing 14 is the vol surface cousin of strike skew, term structure.

[00:11:22] Where we fix the expiry and look at vols for different strikes in the skew, we do the opposite in the term structure.

[00:11:29] We fix the strike, typically at the money, and look at vols for different expirations.

[00:11:34] You can successfully glean a ton of information on a stock simply by glancing at the shape of the term structure.

[00:11:41] You can infer when the earnings will likely be, whether realized vol is high or low, rising or falling.

[00:11:48] Remember, we are all about noticing things.

[00:11:50] If one week implied is 30, one month is 40, and two months is 30, you need not be wicked smart,

[00:11:58] like Matt Damon in Good Will Hunting to surmise that there's an earnings date in there.

[00:12:02] A quick snapshot of the term structure can be found on OVDV space TRMS.

[00:12:08] Is it monotonically upward sloping, likely the case when realized vol has hit the skids

[00:12:13] and folks won't pay up for short-dated options, or is it, like Maverick and Top Gun, inverted?

[00:12:20] The latter features short-dated vol very high and lower on subsequent longer expiries.

[00:12:25] This is often the case when, A, earnings are about to be announced, or B, when realized vol has been extremely high.

[00:12:33] On the latter, let's make a quick connection between the correlation between the VIX futures curve and the level of realized vol.

[00:12:40] With consistency, curve inversions are associated with the higher level of realized vol.

[00:12:45] If I regress the spread between the second VIX future to the first against one-month realized S&P vol,

[00:12:52] I see an R-squared of nearly 50% since 2008.

[00:12:56] That is, UX1 is at a premium to UX2, i.e. the curve is inverted when realized vol is high.

[00:13:03] Good listeners, we have reached thing number 15 of 20 things to do before you ask for a price.

[00:13:11] Altogether, when these four podcasts are over, we'll have had a lot to think about in roughly an hour of time.

[00:13:17] I don't know.

[00:13:18] It feels like time better spent than taking in an hour of 90-day fiancé or Naked and Afraid,

[00:13:24] but I've done both, so I won't judge.

[00:13:27] Number 15 is to understand the vol risk of the trade.

[00:13:30] When we talk about vol risk, we bring in that non-Greek letter Greek called VEGA,

[00:13:36] the risk parameter that cost LTCM a cool $1.2 billion on long-dated equity vol.

[00:13:42] VEGA tells us how much the value of the option will change if we move implied vol up or down a point.

[00:13:49] VEGA risk is prominent in long-dated options.

[00:13:52] In today's zero-DTE craze, VEGA is somewhat of a forgotten Greek.

[00:13:57] These days, it's all about the immediate gratification of an option that will or won't be in the money in a very short time frame.

[00:14:04] But as the sales trader, you should have a quick appreciation for the VEGA risk of the proposed trade.

[00:14:09] And this is for a few reasons.

[00:14:11] First, sizing the trade on VEGA rather than contracts is more meaningful to all parties involved.

[00:14:17] A 200,000 lot of one-month options on SoFi has far less VEGA than a 1,000 lot on Jan 27 MSTR.

[00:14:26] Why?

[00:14:27] Three factors.

[00:14:28] The stock price, the expiration, and the level of implied vol.

[00:14:32] A higher stock price, a longer time to expiry, and a higher implied vol all contribute to higher VEGA.

[00:14:38] What I found useful in defending a trader's price to a client was to be able to quickly translate the bid offer to vol terms.

[00:14:46] For longer-dated options, one vol is worth a lot.

[00:14:49] So a given bid offer price spread might appear larger than it really is once considered in vol terms.

[00:14:56] VEGA is an interesting Greek.

[00:14:58] I might call it the risk you are stuck with it Greek, meaning it's all about mark-to-market exposure.

[00:15:03] You buy something at 50 vol and the market soon decides it's only worth 40, your risk manager might swing by your desk for a side chat.

[00:15:12] You've got to be real careful not to wind up being long or short something that carries MTM risk that will prove terrifying and force a decision at an inopportune time.

[00:15:23] Having populated a pricing model like the OV screen on the terminal, you are in a good position to communicate to the trader because you have your own opinion on the reasonableness of the trade and its VEGA.

[00:15:34] This brings us to a close of part three of 20 things to do before you ask for a price.

[00:15:40] To summarize, things 11 through 15 are to check if the stock is part of some corporate action, evaluate the vol, check the strike skew and the term structure, and compute the vol risk in the trade.

[00:15:52] Next pod, we will close out 20 things.

[00:15:54] But before that, it's critical to wish you all a wonderful Thanksgiving holiday.

[00:15:59] Take some time to really enjoy friends and family and reflect on the good things in life.

[00:16:04] Gratitude is a wonderful state of mind.

[00:16:06] Have a great week, and I will catch you next time.

[00:16:09] You've been listening to The Alpha Exchange.

[00:16:12] If you've enjoyed the show, please do tell a friend.

[00:16:15] And before we leave, I wanted to invite you to drop us some feedback.

[00:16:18] As we aim to utilize these conversations to contribute to the investment community's understanding of risk,

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[00:16:33] Thanks again, and catch you next time.