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Reminiscences of an Option Trader: Deluge


Let's look at the source of this and the effect it is having on the markets.

Last Friday's option expiration was the largest in history. January expirations are by definition much larger than any other because they are "leap" expirations: long term options that trade exclusively for years with no other expirations beside them until one by one as time goes on, monthly options are listed. These leaps then trade even more as traders hedge the new options against them.
This January was even bigger than normal because so much option activity occurred in the months and years following the disaster of 9/11/01.
Upon opening on Friday, the market was weak from a few disappointing earnings and a volatile session overseas. As the day wore on, heavy volume in stocks grew volatile as the liquidity from normal buying and selling was dwarfed by option positions needing to be delta hedged. There was blind buying and selling being done by traders; I readily admit being one of them, whose positions were changing minute by minute and where the exposures were becoming infinite.
You get the picture. The market sold off in the largest move in around eight months. But the move wasn't extraordinary from a statistical perspective; it just looked that way because of the extraordinary lack of volatility preceding it.
The more extraordinary occurrence in my mind has been the last two days. Instead of any trepidation, any pause for concern, any thought to hedging positions, market participants responded to the increased volatility by selling options aggressively. "Aggressively" understates the vehemence with which they reacted; it was like "what is the bid for how many? Sold. What is the bid now?"
This I believe is a function of the "other people's money syndrome". Instead of respecting risk as you might with your own money, funds whose charter it is to "sell volatility" increased risk when they perhaps should be reducing it. I am not saying that individuals who run their own money, as they used to in a much greater degree, estimate risk properly and perhaps would have over-reacted after Friday; I am just saying that these "funds" reacted so vehemently the other way.
Let's look at the source of this and the effect it is having on the markets.
Investors are starved for return. The Fed and other central banks have made it impossible, through their devaluation process of currency (liquidity) for investors to generate reasonable interest income. From savings accounts to money markets, from treasuries to corporate bonds, low risk assets pay diddly. In an economy where wage growth and in general, income generation is lagging credit expansion, investors are coerced to take more risk to generate that necessary "income". But they are having to go up the risk curve steeply to get just a little more return. This is by design by our "wise" bureaucrats: they need people to take more risk from buying stocks to houses to keep an economy going that has lost its manufacturing base. The growing experiment of globalization is looking more and more like Frankenstein.
In other words, investors are ignoring risk to get some, any return.
Enter the new "income funds". Their charters say they can "earn" some bogey rate of return that looks great on paper and when markets are quiet, have a good shot of achieving that return. But at what risk? I believe investors are vastly underestimating the risk (potential loss) they are taking.
So let's look at that risk. My numbers are round, but illustrate accurately what I believe is this most profound situation.
LaLa Income Fund says in their charter that they can "earn" superior market rates of "income". With five-year yields around 4.3%, managers intimate that a realistic "yield" for their fund is 8%. Pick up a prospectus of such a fund and you will be surprised at the cavalier language. LaLa raises $1 billion in capital with that kind of talk.
LaLa targets 8% and must decide how to get there. The strategy involves selling options to earn that "income". LaLa would certainly sell options on a diversified portfolio of stocks (they may be greedy, but they are not stupid), but for our purposes of illustrating risk, let's pretend that portfolio is on one stock. The portfolio manager "likes" BAC (but not too much).
The portfolio manager Bing begins selling the BAC May 47.5 calls at $1.35 and May 45 puts at $.75 to "earn" a total of $2.10 in time premium. With the stock at $47 at the time (January 9), this was a "delta neutral trade" where there was no stock involved. Bing is betting that the stock will stay between $45 and $47.5 to earn his premium of $2.10.
If he earns his full premium he will make $2.10 on a $47 stock price for 130 days. This annualizes into around a 12% return. If Bing takes half his capital and "invests" it at 12% and the other half he keeps in cash at 4%, he will earn his target of 8% return. Sounds pretty good.
But what happens if BAC stock goes to $41, a price where it just traded at just four months ago.
Bing winds up losing $4 on his short puts less the $2.10 in premium he collected for a net loss of $1.90 per option. This would be a nominal (not annualized) loss of around 4% of the fund; combined with his income from his risk free investment this would be a loss of 2.6% to the fund non-annualized. That is a nominal loss and could grow rapidly.
With a loss of 12% on the stock, a perfectly reasonable assumption, an "income" fund has lost 2.6% nominally on a supposedly de-levered portfolio. The losses show that although half of Bing's capital is held in cash, his portfolio is actually very levered. This is the effect short options have on a portfolio.
But some will say that the "trade" is o.k. if Bing begins to sell the stock at $45 or so to "re-hedge" the position. This is a good thought, except it does not occur. One of the main reasons the market has not been volatile is that Bing refuses to re-hedge. He sits there and hopes. His hopes are based on the strange phenomenon we have talked about before: a "feeling" that markets cannot go down because of the immense liquidity being fed into the market by the Fed and other central banks. It has created an illusion, a very strong one, but an illusion none-the-less, that any market problem can and will be healed by more liquidity.
At the same time the market-makers who bought those options trade the "gamma" aggressively, thereby reducing the actual day to day volatility. So Bing is subconsciously also using the fact that he knows that the market-makers trade the gamma to stabilize the stock within a range. The illusion of a range is self re-enforcing.
This of course is faulty logic. It works for a while as long as there are no exogenous influences on the stock. But if real sellers come in, they dwarf the market-makers buying it. The stock is driven down and this leaves Bing very antsy. The market-maker long gamma at $41 is long gone and Bing is left long an awful lot of stock.
Imagine Bing with BAC at $40 and then $39; every dollar loss in the stock equals around a 2% loss in the fund. He has two choices at this point: he can sit with the stock and become a major shareholder or sell it and take his losses, thus driving the stock lower.
But Bing may not have a choice. He has wisely constructed the fund as a closed end fund, so his capital won't be pulled away. But new money certainly won't come in for his investors didn't really understand that they could lose this much money. They knew they were taking a little risk, but not like this. Eventually Bing must face the music.
The discussion above can be translated to the real world only by substituting one stock for a diversified portfolio. This lowers the risk somewhat via diversification, but the risk of capital loss remains very real.
Multiply this by factors and you can see why I say that volatility may be dropping day to day, but compression is building. There are many, many Bings out there. Gaming theory says that Bing may make money for long periods of time, but there will be a time when he will lose precipitously.
This makes Bing a poor risk for reward, although no one knows it yet. The Bings of the world are driving volatility lower and lower, that is, until it breaks out.
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