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Yesterday, I briefly described a trade we did in EBAY as a "collar" trade. In this piece I want to go into some detail about the historical roots of the trade, how it came to be and the relative importance it has had to Wall Street. In another piece I will go into some mathematical detail on the specific trade to illustrate how volatility trading makes money.

The story actually starts in 1989. I was running index and structured product trading in the U.S. for Morgan Stanley. This was a time when computers were really making their impact felt on Wall Street, especially in derivative trading.

Computers were now allowing us to amalgamate positions, to trade one stock and its derivatives against another or an index. Prior to computers, the liquidity in index derivative products like futures and options was very poor simply because it was nearly impossible to trade and analyze for correlation all the component parts (the stocks) of an index. Computers and the subsequent software that was developed allowed quick and efficient analysis to the many moving parts of the index: how much to buy and sell in stock and/or options to replicate the risk of an index. All of a sudden when someone wanted to buy an SPX index option we knew how many individual stock options to buy (GE, IBM, GM, and so on) to hedge the risk.

In May of 1989 I submitted a business plan to my boss at Morgan Stanley illustrating this methodology, termed dispersion, and its likely impact on providing liquidity in index and structured products. By June I was put in charge of doing what I preached.

In August I walked into the derivative sales meeting one morning and showed the best derivative sales group in the world a trade. The market was up 25% so far that year. I asked the following question to the group, "If you were a portfolio manager and up 25% for the year, would you do a trade that would lock in those gains and allow you further upside of 5%, with the cost being that you would be capped out up 5% for a maximum 30% return for the year?"

After a brief silence heads began to nod and then the head of sales and one of the smartest (and nicest) men I have ever met, I will call him Shad, said, "I would do that trade". I then explained the trade: a portfolio manager could buy an SPX index at-the money put (to lock in the gains) and sell 5% out of the money calls (to finance the purchase of those puts), thus capping further returns up 5%. This allowed the manager to maintain his current stock portfolio untouched, a portfolio most likely constructed for alpha (to outperform the market in general) while eliminating market risk.

This was fine but for one problem. At this point relatively few portfolio managers used index options in general and specifically the SPX index up until that time because it had very little liquidity: because there were 500 stocks in the index while being a good representation of the market as a whole, it was difficult to hedge.

The OEX was popular with speculators because it was liquid and a reasonable market proxy. It was liquid because it was easier to hedge having only 100 stocks and became even more liquid because of the speculation, a circular phenomenon. But portfolio managers were reticent to use the OEX to hedge market (systematic) risk because for their purposes the tracking error or low correlation it had to the broader market was too great; thus the quandary.

Not to worry I said to the salespeople, we will provide the liquidity. Shad pulled me aside as we all walked out and asked me to be sure of what I was saying (although he appreciated the risk I was taking, he also understood it), because he was going to show this trade to one of our biggest clients, a pension fund.

Later that day he called me into a conference call with the client where we went over the details of the trade. The question of liquidity was raised again, not only for getting into the trade but for getting out of the trade. Someone somewhere always takes the risk for something new. This was my time to do so; I was confident. I assured them of liquidity.

The next morning we had the order: hedge $1 billion. Shad left one black ticket and one red ticket on my desk with some parameters, smiled, and walked away. This would be a moderately sizeable trade today, but back then it was a monster trade. More importantly, given the fact that it was in the SPX where there were currently three local market makers in the pit it, was a dangerous trade.

I waited for the market to open and trade for a while, then called down to the floor for a market in the calls and the puts. We quickly termed the combination of options a "risk-reversal" based on the fact that it was a risky version of what we called a reversal. "Even bid to buy calls and sell puts fifty contracts" was the response from my floor broker. I instructed the broker to, "Sell 10,000 at even and buy what you have to." After confirming and re-confirming the amount the broker executed the order; I was as you would expect 95% of the trade.

I left the order open to any market makers to participate on the trade. After futures settled down and delta hedges were established, I began giving up the trade to the floor. The size and nature of the trade began to get around to other large market makers who barely knew where the SPX pit was. By the end of the day the number of market makers in the pit had grown to about twenty.

The trade was a brilliant trade, not for the execution, but for what it accomplished strategically for the client. For its size it was written up in the Wall Street Journal, but for its efficacy it caught on with investors (it helped that the market endured a significant correction in October). Morgan Stanley dominated trading in index and structured products for the next ten years through a combination of ingenuity, execution, and salesmanship.

These "collar" trades became very popular in single stocks as well. They started first in listed options, but quickly gravitated to OTC options for their anonymity and more importantly their flexibility. Using OTC options we could tailor make strikes and other terms like exercise risk and expiration. This then developed into a swap with imbedded options for tax reasons and lending issues. I alluded to the fact yesterday that the EBAY trade in the listed option market was the result of the broker-dealer taking off gamma risk from one of these OTC trades.

These swaps called "variable forward contracts" were predominantly used by affiliates of companies all through the 1990's who held large blocks of stocks. Theses customers could accomplish several things with these swaps: they could not only eliminate their huge stock specific risk (diversify), but they could do it on a tax deferred basis (if they sell the stock they incur a tax liability right away) and enjoy liquidity through an associated loan using the position as collateral.

This particular product drove huge revenues for Wall Street for many years. Like many things in this business or even in life, it had quite humble beginnings.
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