20 Things to Do Before You Ask for a Price (Part 4)

[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] Welcome back to the last installment of 20 Things to Do Before You Ask for a Price.

[00:00:25] Please examine your boarding pass to ensure you are on the right flight before we leave the ground.

[00:00:30] We are heading on the final leg of our journey to a firm understanding of how a derivative sales trader can be a meaningful part of getting two institutional counterparties to yes with respect to the transfer of option risk.

[00:00:44] The sales trader sitting between the trader and the client can quarterback the process by appreciating the context of the trade and contributing insights on the risk profile of it.

[00:00:56] Context is about the client, the underlying stock, the trade motivation, and the risk environment.

[00:01:02] The risk profile is about the many nuances of different option trades and what they imply for how the sell-side trader will think about pricing and providing capital.

[00:01:12] 20 Things is about the sales trader being an effective advocate on his or her trader's behalf and empowering that trader to take more sensible and, as a result, more risk.

[00:01:22] With a well-thought-out playbook for price discovery between trader and client, a greater likelihood of win-win becomes achievable.

[00:01:31] More business results.

[00:01:33] Let's finish with things 16 through 20.

[00:01:36] The first of these is to calculate what the bid offer of the trade is in vol terms.

[00:01:41] I made the point on part three of 20 things that one must know that short-dated options are considerably more gamma-intensive and long-dated options carry more vega risk.

[00:01:53] It's important when quoting a two-way market on a longer-dated option to appreciate how a given bid offer in price terms translates into a bid offer in volatility.

[00:02:02] Here's a simple, stylized example.

[00:02:06] Using 15 implied vol, a one-month at-the-money straddle on the S&P costs 3.67%.

[00:02:12] A two-year straddle using the same implied vol costs 16.7%.

[00:02:18] Suppose each straddle is quoted 25 basis points wide.

[00:02:24] Pricing both straddles in the same bid offer sounds similar, but the reality is that the vol bid offer for the two-year straddle is considerably tighter than that of the one-month straddle, as its vega is nearly five times that of the one-month straddle.

[00:02:39] As a salesperson, you want to appreciate vega risk.

[00:02:43] Getting the vol wrong when the vega risk is high can yield mark-to-market losses that the trader will bear for a long time.

[00:02:50] Sizing becomes really important in these longer-dated trades.

[00:02:54] Another facet of trades that have a high degree of vol risk is in understanding the client's full picture to the extent possible.

[00:03:01] In other words, if a client is buying longer-dated options and you have provided the capital on that trade, it's not a great result if this is simply tranche one of many still to come.

[00:03:12] If the second and third slugs come at higher vols, your trader has the difficult choice of adding at higher levels but taking on more risk in the process or allowing it to trade away but seeing the fresh demand mark the original position further against it.

[00:03:28] I'm recalling the summer of 2002, which saw the advent of capital structure arbitrage trades in which a fund would sell CDS and cover the tail risk through deep out-of-the-money put options.

[00:03:40] Credit spreads had blown out during the recession that came on as the tech bubble popped.

[00:03:46] And it wasn't the case that sell-side credit and equity-derivative desks were in close touch with each other on the price of cross-asset risk.

[00:03:54] The emergence of demand for deep downside puts at extremely high vols was a new, not properly understood thing for equity-derivative desks.

[00:04:02] And it was often the case that stock prices could rise, but just from the sheer magnitude of demand from the cap structure ARB community, far OTM put prices could rise on the back of surging implied vol and SKU.

[00:04:18] If you were the first to sell these low delta puts and unaware of the vast buying interest that would soon follow, you were nursing mark-to-market losses that were impossible to get back.

[00:04:30] Let's go to thing number 17, and that is to look at the combo.

[00:04:34] The put-call combo, that is.

[00:04:37] Check the implied vol on the put versus the implied vol on the call of the corresponding strike.

[00:04:42] Are they reasonably the same?

[00:04:44] If not, there could be a borrow or dividend issue.

[00:04:47] When put vol is much higher than call vol, a borrow issue is often present.

[00:04:51] In instances where the market is forecasting an increase in dividends, it's also the case that the put vol will be higher than the call vol.

[00:05:00] Remember, Black Shoals is built on a market unburdened by what has been.

[00:05:04] Oh, sorry, that was Kamala.

[00:05:06] I meant to say unburdened by frictions.

[00:05:08] There are no stock loan issues in the neat world of Black Shoals in which borrowing and lending rates are always the same.

[00:05:15] By quickly seeing if there's some deviation in the put-call combo, you may well be coming across a risk-arb deal or other corporate action in which shorting the stock is expensive as there are supply issues.

[00:05:27] This ties back to the CACS page on Bloomberg that will show whether the stock is subject to an impending merger.

[00:05:36] Thing number 18 is to understand dividend risk.

[00:05:39] First, let's note that the most basic form of the Black Shoals model is to price a European option on a stock that does not pay dividends.

[00:05:48] Many stocks do, in fact, pay divs.

[00:05:51] That dividend stream needs to make its way into the option pricing model, like both the funding and stock loan rate, through the forward price of the stock.

[00:06:00] For most options, dividend risk isn't a big deal.

[00:06:03] Companies don't like to surprise investors, especially in cutting dividends.

[00:06:07] Adding to this, so many U.S. listed options have very short-dated expirations.

[00:06:12] The likelihood is that the option's life will not include an ex-dividend date.

[00:06:17] Dividend risk, like interest rate risk, is more significant for longer versus shorter-dated options.

[00:06:23] Get either wrong over a long time frame and you've mispriced the forward and the option as a result.

[00:06:29] But longer-dated dividend risk, unlike interest rate risk, isn't all that hedgeable.

[00:06:34] In the world of listed options, there are trades that are surely zero-sum.

[00:06:39] The option buyer is very likely to make money at the option seller expense should a spike in vol occur, perhaps based on some broad increase in macro uncertainty.

[00:06:49] It happens all the time.

[00:06:51] Here, the initiating party hasn't necessarily done anything wrong.

[00:06:54] With respect to longer-dated dividend risk, it's considered bad form or worse to capitalize on some information asymmetry.

[00:07:03] Suppose your client calls you up looking for a two-way price on two-year 70 delta risk reversals on a single stock.

[00:07:11] I want to buy, put, sell, call, and buy the stock delta neutral, she says, eager to explain that it's just a skew trade.

[00:07:18] Ah, the lessons we sell-siders are forced to learn.

[00:07:21] The trade goes up delta neutral, your trader wears the risk, and the desk is cautiously celebrating the large commission haul.

[00:07:28] Not but a week later, the vols on the trade mostly unchanged.

[00:07:32] The company has announced a large dividend increase, effective next quarter, and payable eight times over the course of this now unsavory, quote, skew trade.

[00:07:43] Not priced into the risk reversal was the risk that your trader's short stock hedge was going to be taxed by this quarterly dividend payment.

[00:07:52] The put-call trade reprices substantially, not on a change in vol, but on a dramatic change in the forward.

[00:07:59] The street starts to realize it's been had on these long-dated, quote, skew trades, as the client's capacity to foresee dividend increase is uncanny.

[00:08:09] Think of dividend risk as being a joint function of the delta and the expiration of the trade.

[00:08:15] Higher deltas and longer-dated expiries add to dividend risk.

[00:08:19] We are officially closing in on the end of 20 things to do before you ask for a price.

[00:08:26] How exciting is it to have reached this point?

[00:08:29] And thing number 19 is to know put-call parity.

[00:08:33] C equals S plus P minus the present value of K.

[00:08:37] The premium for a call option is equal to the sum of the stock and the put price minus the present value of the strike price.

[00:08:45] This little formula tells us that calls are puts and puts are calls.

[00:08:50] If I can borrow and lend and I can buy or sell the stock, I can compute the price of a put if I know the price of the corresponding call of the same strike and expiry.

[00:09:00] Knowing the call, in turn, will allow me to back into the price of the put.

[00:09:05] No assumptions about the economy or stock price distributions.

[00:09:08] No calculus.

[00:09:10] Of the same strike and expiry, the put and call are linked because in combination, I can replicate the stock itself.

[00:09:18] You want to be fluid in translating puts to calls and back via put-call parity.

[00:09:23] In doing so, you can help advance the conversation on deep in-the-money options especially.

[00:09:28] For example, your client has hit it big on MSTR call options.

[00:09:32] He's cashing in on some of these huge gains, selling calls that are now deep in the money and carry a 90 delta.

[00:09:39] For the purpose of facilitating the order, he'll do it neutral, buying the stock.

[00:09:44] Your trader is going to be left long a deep in-the-money call and short a lot of stock on a full hedge.

[00:09:51] Put-call parity tells us that the delta of an in-the-money call is the equivalent of buying a 10 delta put and the vol paid ought to line up.

[00:10:00] Put-call parity in thing 19 is what cements thing 17, looking at the combo, and thing 18, understanding dividend risk.

[00:10:08] These all relate to the impact of the forward in pricing, puts, and calls.

[00:10:13] Thing number 20 brings it all together.

[00:10:16] It's to have an opinion on every single price you get from a trader.

[00:10:21] You should have a feeling of what you think the price should be before you get a price.

[00:10:26] How could you not?

[00:10:27] You've just executed 20 things.

[00:10:29] You're not going to ultimately be responsible for making the price.

[00:10:33] That's your trader's job.

[00:10:34] But your informed input is critical.

[00:10:37] You can, and because the business is so competitive, must play a role in helping your trader evaluate the incoming risk.

[00:10:45] To review, the institutionally sized listed options transaction is a very unique proposition.

[00:10:52] In a matter of moments, a light fires up, counterparties engage, a price is secured, and the risk is transferred.

[00:11:01] In the best of circumstances, a lot can go wrong.

[00:11:04] Option risk lives, breathes, and evolves as time passes and the underlying asset moves in price.

[00:11:10] Hedging is inexact, littered with frictions and path dependent.

[00:11:15] One party's gain can often be another party's loss.

[00:11:18] And because the sell side is short information asymmetry, the trader needs a salesperson capable of engaging in the price discovery process as a partner.

[00:11:28] There are no bonuses to be paid out of magical sales credits or out of commissions alone.

[00:11:33] The success of a flow desk is having a lot of action, a diversified client base pursuing many different strategies.

[00:11:41] It's important that the client base places value on pricing consistency.

[00:11:48] A desk that wins a trade only as a result of having the best price each and every time is unlikely to enjoy long-term success.

[00:11:56] The client ought to expect a healthy dose of capital commitment, to be sure.

[00:12:00] But the right clients will also value a repeatable process in which the salesperson and trader speak the same language.

[00:12:08] That doesn't mean every client will.

[00:12:10] Some will choose the jump ball auction process for each trade.

[00:12:14] That's okay, but it's a difficult business to make work for the sell side.

[00:12:18] The salesperson cannot merely be a go-between that connects the dots between the client and trader.

[00:12:23] There may well be some role like that somewhere on Wall Street, but there's nothing about it that should be well compensated for.

[00:12:30] The salesperson's value proposition derives from having a deep understanding of the nuances of each incoming order

[00:12:36] and what they imply for the fast-paced price discovery process that ensues nearly immediately.

[00:12:43] Last point on 20 things and how the salesperson can add value.

[00:12:47] Sometimes it's the trades you don't do that define success.

[00:12:51] In the case of the short info asymmetry sales trader, the concept of, quote, good miss likely resonates with some frequency.

[00:13:00] Option trades are inherently risky and with no intention to do so, client business can inflict loss.

[00:13:06] It's easy to miss trades you don't want to by submitting a truly uncompetitive price.

[00:13:11] But if the client relationship hinges on consistency of pricing, you may find yourself penalized for coming in last.

[00:13:19] Some part of the art of option sales trading is finding a way to miss gracefully on trades that truly do not fit the book or on trades for which the risk profile is deemed unattractive.

[00:13:31] Coming in second or, at worst, third in seeking to lose a trade ought to be part of the exercise.

[00:13:37] Here again, the salesperson is contributing his or her informed view on where a trade will get done and guiding the trader to be slightly worse than that.

[00:13:46] This brings us to a conclusion of 20 things to do before you ask for a price.

[00:13:52] In today's highly electronified markets, prices are streamed continuously by tireless bots with neither faces nor names.

[00:14:00] But risk transfer still does occur the old-fashioned way as well.

[00:14:04] And these voice trades require superb communication, led by the sales trader.

[00:14:10] If you are executing upon 20 things, you are adding alpha to the process.

[00:14:14] I hope this four-part series has been interesting and you've enjoyed the perspective.

[00:14:19] Until next time, have a wonderful upcoming week.

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