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Minyan Mailbag: The Ramifications of Premium Selling


Everyone is starved for income and taking more and more risk to get some return.


Prof. Succo,

I read with great interest your January 25 piece on the January expiration and the ramifications of premium selling. I offer up a few comments and questions for your consideration.

1. The "liquidity illusion" was only further reinforced last week by the persistent bid before, during and after the Bernanke hearings, ironically occurring during an option expiration week. It would have been unacceptable for the stock market to react negatively to these hearings and it would certainly have made the likes of Bing quite nervous; hence it rallied and unashamedly left some footprints that smart observers like Santoli picked up on: "Each day last week, stocks wobbled and traders dissembled through midday, only to see a flurry of purchases hit the tape into the close."

2. Bing will also have a problem should the large caps stage a massive breakout to the upside, but he worries about this much less because it represents opportunity cost instead of dollar loss and he can trumpet the fact that he's "earning" his 8% mandate even as the market rallies by 25%. But his investors will not be so quick to congratulate him.

3. I think a strong case can be made that the activities of the Bings has contributed mightily to the stagnation of the large caps in recent years, beyond the increased appetite for riskier assets. The price you pay for the trusty bid below the market is an equally trusty offer above the market. Since mid-2003, the volatility of the Russell 2000 has been just about flat while big cap volatility has continued to steadily decline. And over this period, the RUT has outperformed the S&P by about 25%.

4. To what extent do you feel that hedge funds are doing the Bing thing? One reads a lot of "don't worry" pieces about how de-levered hedge funds are these days relative to the 1990's, but does this miss the hidden levering of premium selling?

5. Any gross comparison of put and call volume with a view toward getting a clue on investor sentiment has become a waste of time. In the Bing world, the creation of a put position is identical in purpose and outlook to the creation of a call. The only difference is that compression builds on the put side because Bing may one day be a forced seller of his shares.

Prof. Schaeffer

Prof. Schaeffer,

Your first point speaks to what I have been observing and discounting in my trading process: it seems to me that markets are more and more "intervened" upon, hiding cause and effect and cajoling markets into a desired state. Participants are made to think that monetary policy is working, while all the while it is adding to the problem of over-capacity and debt.

Premium sellers will have explaining to do to their unaware investors with any return to normal volatility in stocks while their activities have without question reduced volatility by definition. For an explanation as to how, please refer to my description on how this short gamma reduces actual volatility while markets remain in a range. Of course it will have the opposite effect of increasing volatility dramatically once the market "breaks out" one way or another.

Compression builds from the Bings of the world and from all other participants who have outsized risk because of the lack of volatility. Hedge fund managers may not be selling options directly (although I am sure some do), but they have the same risk profile by running "short convexity" strategies. An example of this is the manager who is depending on any spread (long one stock, short another or long credit, short treasuries) on leverage and dependent on that spread remaining intact.

Everyone is starved for income and taking more and more risk to get some return. The problem is that income is much different from capital risk, although no one is treating it that way.

-Prof. Succo


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