Mike Lipkin
Mike Lipkin
Mike Lipkin
Mike Lipkin
Dynamics: Everything on the Screen is time-varying at highfrequency. Nevertheless: Economists (especially), Financial Mathematicians, Physicists, etc. have attempted to model what prices are seen on the screen, often by suppressing time-variations at these frequencies. This is not unreasonable, but it does not reflect the reality of exchange trading.
Mike Lipkin
Mike Lipkin
b)
c)
Mike Lipkin
d)
A consistent valuation of option prices needs the underlying variables of the stock process: interest rates, volatility or standard deviation of the stock price movement, dividend dates and amounts, etc.
BUT: e) Option valuation is independent of other factors especially (but not limited to) supply and demand for options and stock.
Mike Lipkin
In actual floor and screen trading, all these conditions are violated.
t= tnow
tchar
texp-
texp
Mike Lipkin
Mike Lipkin
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As an example, we concentrate on XYZ Nov 50 calls for the next several slides.
Mike Lipkin
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XYZ
Nov 50 C
Scenario A: 10:03:00 initial market 10:03:30 Buy 50 calls at the market 10:04:00 Sell 50 calls at $1.50 Scenario B: 10:03:00 initial market 10:03:30 Sell 50 calls at $1.50 10:04:00 Buy 50 calls at the market
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1.50
1.50
10:03:00
10:04:00
B:
1.50
1.50
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--Specialist: You bought 500 at 1.60, 500 more at 1.70; the ISE is at 1.70, Ill try to clear the away market.I only bought 100 at 1.70 away; theres 500 more at 1.75, Ill try to get those.
Mike Lipkin QuantCongress Europe/NewYork November 2005/Stern February 2006 14
Mike Lipkin
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LEANING:
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An estimate of the deltas for the XYZ Nov 50 calls with the stock at $32.70 might be 20. The broker has bid for 100,000 deltas. So far he has bought 84,000. HOW MUCH STOCK HAS THE CROWD BOUGHT? A LOT, maybe 125,000!!
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VALUATION:
During all this flurry of trading, the market-makers are adjusting the theoretical valuations of the options. WHY? Because traders dont input the measured stock volatility of a model and get a price. They plug the trading price of the option into a model and arrive at a volatility. When trading began, Nov 50 calls were worth $1.50; now they are valued at $1.80+. So without the stock moving the price has increased by 30.
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Valuation continued
A trader in the crowd has increased the volatility he uses for Nov 50 options by 10 clicks. He raises the Dec options on the 50 line by 5 points and the 45s and 50s by 3 points. This is all heuristic, seat-of-the-pants fiddling. When he does this, it turns out that the Feb 45 puts have a new theoretical value. Originally he thought the puts were worth $14.34. Feb 40 P 14 14.40 Trader: Feb 40 puts, 14.40 for 50 Specialist: 32 there. You bought them.
Mike Lipkin
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Valuation continued
Later in the day the stock is trading 35.25. With nothing on the book the market reads: Nov 50 C 2.65 2.85 (200x200) Trader A is short 500 deltas. The same broker enters the crowd and asks for the market. Without hearing what order the broker has, he immediately tries to buy deltas, selling puts, buying calls and stock. Specialist: 2.65-2.85 200-up Broker: Where do 500 come?
Mike Lipkin QuantCongress Europe/NewYork November 2005/Stern February 2006 20
Valuation, cont
What is the role of an equilibrium model? Once the new prices are stable, calendars and verticals are priced off the standard models.
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Mike Lipkin
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RISK:
So supply and demand is the principle reason for marketmakers to change their valuations. But there is another powerful effect, which is a direct consequence of Options Trading as Games Playing.
That is RISK. Strong effect on tail valuation.
Mike Lipkin QuantCongress Europe/NewYork November 2005/Stern February 2006 23
Scenario
Consider a trader with the following risk profile: Stock ZYX at 65.75 Up 25% he loses $900,000 Down 25% he makes $80,000 (volatilities unchanged for this simple example)
-900K = visit to unemployment, sale of apartment, etc
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Risk, cont
Many factors contribute to the net safety of a traders position:
a) b) c) d) e) Net calls Net puts Vega Dividend/interest rate Decay
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Risk, cont
These concerns can be rewritten in more suggestive terms. Some risk factors are:
a) too short premium (blow out risk for big moves) b) too long premium (decay risk for small movements and contraction risk for steady up moves) c) volatility risk (especially long term contracts) d) interest rates e) take-over risk f) hard-to-borrow (buy-in risk)
Mike Lipkin QuantCongress Europe/NewYork November 2005/Stern February 2006 27
Takeovers
(An abbreviated option board:) Oct 30C 6.5 Dec 30C 8.5 Apr 30C 11.25 Oct 40C 2.5 Dec 40C 3.75 Apr 40C 5.85 Oct 50C 1.25 Dec 50C 2.75 Apr 50C 4.80 XYZ is trading 30 at the end of September. The 50 strike is the highest strike available. All of a sudden, the order flow in the Apr 50 calls becomes brisk and one-way. Can you guess which way?
Mike Lipkin QuantCongress Europe/NewYork November 2005/Stern February 2006 28
Takeovers, cont
Brokers (or electronically): Sell 200; Sell 300; Sell 500 No one consults a theory. The implied volatility on all the 50 lines gets crushed; the volatility in the late months gets reduced. At the same time orders come in for strange spreads: Broker: Give me a market in the Oct 30-40 1-by-2. The screen value is $1.50. What market does he get?
Mike Lipkin QuantCongress Europe/NewYork November 2005/Stern February 2006 29
Takeovers, cont
Specialist: .80-1.25 500-up. What would you rather do? Buy or sell the 1x2? What if XYZ is acquired for $53 in cash? The premium on the options will all fall to near $0! The Apr 50 calls will be worth $3, less than they are now! The 1x2. The 30 calls make $23, the 40 calls make $13. 232(13)= -3. Anyone buying the 1x2 loses $3 on the spread PLUS what he paid for it. We dont have to prove to the SEC that people know a deal is imminent. The order flow has told us.
Mike Lipkin QuantCongress Europe/NewYork November 2005/Stern February 2006 30