20 Things to Do Before You Ask for a Price (Part 2)

[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] All right, folks, we are back with installment number two of 20 Things to Do Before You Ask for a Price.

[00:00:26] It's a to-do list for the equity derivative sales trader who chooses to be a relevant and constructive part of the option risk transfer process that a buy-side client and sell-side trader engage in.

[00:00:37] I keep thinking about how unique an institutional options trade is.

[00:00:41] Folks on a desk are taking part in some lighthearted banter, perhaps debating how well Matt Gaetz will do as Attorney General, or better, planning an epic lunch order.

[00:00:51] And then, in the blink of an eye, a light is flashing. It's picked up.

[00:00:55] A trade is contemplated and then priced by the trader who tells the salesperson who relays to the client, who then tells the salesperson, who then finally tells the trader.

[00:01:06] A transaction might result.

[00:01:08] What was nothing moments earlier can become a very large trade in just seconds.

[00:01:14] Small trades, like buying a pack of gum, can be consummated quickly.

[00:01:18] Large trades, like buying a house, typically take a while.

[00:01:21] But large trades that are born in a moment's notice, that's a unique thing.

[00:01:26] The sell-side trading desk earns the commission.

[00:01:29] And it trades on the right side of the bid offer, or at least in theory.

[00:01:33] But it is vastly short information asymmetry.

[00:01:37] That call is coming in for a reason.

[00:01:39] The client has thought carefully about the risk and opportunity embedded in the trade he or she wants a price on.

[00:01:46] That's why 20 Things is important.

[00:01:48] It's a risk management exercise that the sales trader ought to do on his or her trader's behalf.

[00:01:55] As I said last time, commissions are nice, but not at the expense of heavy trading losses.

[00:02:00] Let's quickly run through things one to five.

[00:02:03] Know the client.

[00:02:04] Know the risk environment.

[00:02:06] Know the trade motivation.

[00:02:07] Know something about the stock.

[00:02:09] And lastly, buy yourself some time.

[00:02:11] On this concept, we can substitute the word time for optionality.

[00:02:16] Time is money, as they say.

[00:02:18] Giving you and your trader just an extra few seconds to evaluate the trade makes a small contribution to reducing the inherent asymmetry of information.

[00:02:27] Things one to five are really about having a good grasp of context.

[00:02:32] About the client.

[00:02:33] About risk.

[00:02:34] About the trade.

[00:02:35] And about the underlying in question.

[00:02:37] All well before you even dare ask your trader for a price.

[00:02:41] Like most things in life, context is cumulative.

[00:02:44] You don't simply arrive one day and decide to be good at things one to five.

[00:02:49] You gotta practice.

[00:02:51] So, let's move on to things six through ten.

[00:02:54] Before we do so, I have to mention that this past weekend,

[00:02:57] I witnessed both the ridiculous and the sublime in the field of combat sports.

[00:03:02] The Tyson-Paul fight.

[00:03:04] Sheesh.

[00:03:05] I read all the frustrated takes post the fight.

[00:03:08] What did you really expect?

[00:03:09] Many of us are huge Tyson fans.

[00:03:13] His serious personal demons notwithstanding because of the Iron Mike days of the 1980s.

[00:03:19] But we must acknowledge that father time has been and will always be undefeated.

[00:03:24] Just ask Joe Biden.

[00:03:26] The very next night, post the act in Arlington, as one might name that boxing exhibition,

[00:03:32] I took my son Liam to the UFC at Madison Square Garden.

[00:03:35] Trump had his full entourage there.

[00:03:38] Tulsi and RFK, Vivek, and Elon.

[00:03:41] My favorite was Kid Rock.

[00:03:43] Already there waiting for him outside the octagon as his Trump anthem, American Badass, blared.

[00:03:49] I'm not sure of a more Trump-obsessed demographic than the UFC fan base.

[00:03:54] Anyway, the title fight featured Jon Jones versus Stipe Miocic, and it ended in spectacular fashion with a spinning back kick from Jones,

[00:04:04] connecting directly to the ribs, flattening Stipe in the fourth round.

[00:04:08] Let's go back to 20 things.

[00:04:10] Number six is whether the order is outright or delta neutral.

[00:04:14] My goodness, this matters a ton and really shapes the kind of interaction you'll have with your client and your trader.

[00:04:21] Put simply, the outright order, i.e. one without any stock traded against it, greatly speeds up the timeline of events.

[00:04:29] When an order has delta risk, speed of communication is of the essence.

[00:04:34] And the more delta, the greater degree that immediacy will be emphasized.

[00:04:38] Decision-making is accelerated for outright orders.

[00:04:42] You pick up that light and take in whether the order is outright or delta neutral,

[00:04:46] and you can almost experience a bodily response on how the coming seconds will transpire.

[00:04:52] It's a really different experience.

[00:04:54] Your voice even sounds different as you get the trader's attention depending on whether the order is live or tied, as they say in the jargon.

[00:05:02] Live means this trade is being priced and potentially transacted to almost immediately.

[00:05:09] The urgency in your voice says so.

[00:05:11] Tied or delta neutral has a slower pace to it.

[00:05:14] The price discovery process has the trader thinking about vol, not delta risk.

[00:05:19] The trader may solicit the opinion of layoff accounts to see where they live on the trade.

[00:05:24] You are most likely calling the account back.

[00:05:27] When an order is delta neutral, the client will give you some time to price it.

[00:05:31] And in turn, you will give the client some, but not too much, time to noodle on that price.

[00:05:37] Remember, stock prices move, and so do vol levels.

[00:05:41] A delta neutral price should also have an implicit expiration date, lest the client be long another option.

[00:05:47] Suppose, for example, you price options on Microsoft delta neutral at 22 vol.

[00:05:53] Over the course of the next 10 minutes, the VIX goes from 15 to 18.

[00:05:57] It's a good bet that that 22 vol isn't the right price anymore for those Microsoft options, given the move higher in the VIX.

[00:06:05] So you have to be careful and manage expectations.

[00:06:08] All right.

[00:06:09] Thing seven is to check the option market depth.

[00:06:12] I'm a Bloomberg lifer.

[00:06:14] It's my adult version of Minecraft.

[00:06:15] So I'm using the OMON page to see the vast array of put and call prices for an underlying buy strike and expiration.

[00:06:25] Get quickly to the line in question.

[00:06:27] What's the bid offer width?

[00:06:29] How many contracts are on the bid or offer?

[00:06:32] Is liquidity posted consistently?

[00:06:34] If the trade in question shows the screens two cents wide and a few thousand on both the bid and offer,

[00:06:40] the market's done the lion's share of the price discovery process for you.

[00:06:44] However, there are certain underlyings and HYG is one of them where the actual liquidity is far greater than that displayed on the screen.

[00:06:53] On November 18th, for example, the Jan 79-74 put spread traded in the HYG 10,000 times at 53 cents.

[00:07:01] The two legs were 66 cents and 13 cents.

[00:07:05] Post the trade, what was the bid on the lower strike, the 74 put?

[00:07:10] I'd go back to Dean Warmer's 0.0 for Blutarski, but it was actually more like Daniel Simpson's you have no grade point average.

[00:07:19] There was literally no posted bid on a put strike that had just traded in good size.

[00:07:25] You'd think that the counterparty to that trade would have at least deigned interest in a repeat transaction.

[00:07:30] These vol bots have little personality and little conscience.

[00:07:35] This OMON page is a great starting point to take in a lot of information.

[00:07:39] And while you check the particulars on the line of interest,

[00:07:42] take a look at surrounding strikes to gather further context on liquidity.

[00:07:46] What is that thing numbered eight, you ask?

[00:07:49] I did write this 20 years ago, so let me consult my notes.

[00:07:53] Here it is.

[00:07:54] Check volume.

[00:07:55] Yes, a couple of ways to do this, but I like the OMST page on Bloomberg.

[00:08:01] You can quickly see what's traded, how that volume compares to recent volume,

[00:08:05] where the trades are concentrated delta-wise, and what the breakdown is between put and calls.

[00:08:11] Recall the podcast I did a few weeks back, The Opera of Option Prices.

[00:08:16] That detailed the surge in call buying on the FXI as part of the effort to capitalize

[00:08:21] on the Chinese government stimulus campaign.

[00:08:24] Again, what you're trying to do is notice things.

[00:08:27] If the volume is heavily skewed towards out-of-the-money puts,

[00:08:30] and the volume is much higher than it normally is, you want to be asking yourself why.

[00:08:35] Is there a corporate bond or a CDS out there that these puts might be traded against?

[00:08:40] As you look at this page, one or two trades might stand out.

[00:08:44] Perhaps, for example, there are 12,050 strike puts and 24,040 strike puts that have traded.

[00:08:51] It's not a bad bet that this might be a one-by-two put spread.

[00:08:55] Take a look at the vol spread and the net price.

[00:08:58] Ask yourself, would you do that trade?

[00:09:00] Thing nine.

[00:09:01] Yes, it's time.

[00:09:02] And that is, what's the options delta?

[00:09:05] Delta should be thought of in the context of delta per option times how many options.

[00:09:10] That is, the number of shares that are at risk in the contemplated trade.

[00:09:14] And of course, this should be benchmarked versus the liquidity of the underlying on a standard day.

[00:09:20] As I said earlier, the outright versus delta neutral order are different beasts with different paces to them.

[00:09:26] The outright order makes your vol geek of a trader into a cash equity block trader,

[00:09:31] whether he or she has willingly chosen that line of work or not.

[00:09:36] One might say that your trader can't get the vol right if he can't get the delta hedge on at the right price.

[00:09:42] Let's talk about delta risk.

[00:09:44] I want to explore this by bringing in an exercise I used to do in presenting to analyst training classes.

[00:09:50] We'd simulate an ETF trade, which we can think about as an option trade where the delta is 100, i.e. a put-call combo.

[00:09:58] Client light fires up.

[00:10:00] Q's 500 is all you hear.

[00:10:03] You instantaneously run through your checklist on the client risk, the trade.

[00:10:07] On the buy yourself some time idea, that's not really applicable in this context.

[00:10:12] Everyone knows the triple Q.

[00:10:14] You don't want to be repeating what this vehicle does back to your client.

[00:10:17] Now, because we are in a very, very competitive business, a rapid speed of response is expected.

[00:10:23] You get a price and relay it in a second.

[00:10:26] Remember, this is a 100 delta and the client called you, not the other way around.

[00:10:30] It's feasible that your team is short some information asymmetry here.

[00:10:34] And when you are short that, then reducing the optionality that originates from time is critical.

[00:10:40] That is, when you relay your trader's price back to the client, you, in turn, should expect a nearly instantaneous response.

[00:10:48] So, in simulating to the incoming analyst class how things can break down in an ETF trade requiring capital, the client takes in the price and simply says nothing.

[00:10:58] Tick.

[00:10:59] Tick.

[00:11:00] Even an extra second can be of value if the market is fast moving.

[00:11:04] The client is long the option to trade or not to trade.

[00:11:08] Waiting a second or two might push that option in the money.

[00:11:11] In a sub-15 VIX environment, it might not really matter.

[00:11:14] But it's clearly not a sustainable business practice to be granting optionality for free, especially on a consistent basis.

[00:11:23] The correct response from the sales trader is something like, out updating.

[00:11:27] That is, we are refreshing the price at which we're ready to trade.

[00:11:31] The point is that you are your trader's line of defense on delta risk.

[00:11:36] If the trade's delta is a chunky percentage of a day's volume, articulating that should roll off your tongue and to the client.

[00:11:43] There's a price for everything, and winning the business is really competitive.

[00:11:47] And liquidity generally is not created out of thin air.

[00:11:51] All of these are true at once.

[00:11:53] Okay, our next thing to do is check earnings.

[00:11:56] That's thing number 10.

[00:11:57] The ERN function is a beauty on Bloomberg.

[00:12:01] Earnings is a mainstay in what I call on-the-calendar catalysts.

[00:12:05] We know the date four times per year that a company reports.

[00:12:09] We know that realized vol on earnings days is three to six times that on non-earnings days.

[00:12:15] And we know that options traders are a greedy bunch.

[00:12:18] These folks would have you sell them options that expire after earnings and have you buy ones that expire right before expiry.

[00:12:26] The nerve of these profit seekers.

[00:12:28] The market, of course, prices options that contain the release of earnings with a greater value than those that do not.

[00:12:34] This ERN page has got a lot of information.

[00:12:37] All of the earnings dates, the stock moves, the extent to which earnings surprises are on that earnings release.

[00:12:43] There's an implied move calculation as well, which is the result of the relative prices of options that expire before and after earnings.

[00:12:52] We want to be armed with as much context as possible to understand the risk profile of the trade.

[00:12:59] If it's over an earnings date, the option is going to have not just an elevated level of implied vol, but if the playbook is correct, a large stock price move on the earnings date and a subsequent sharp move lower in the implied vol level.

[00:13:13] Take a look at these historical earnings moves and how volatile they are.

[00:13:17] NVIDIA is a good example.

[00:13:19] It reports again on November 20th.

[00:13:21] Its implied move is 8.8% as of this writing two days prior to earnings.

[00:13:26] The average absolute price move on earnings days is 7.4%.

[00:13:31] But there have been some gigantic moves.

[00:13:34] A 24% surge on May 25th of 2023 as Q1 earnings were reported.

[00:13:40] A 16% spike post the Q1 2024 release.

[00:13:44] The largest company in the S&P has a 90% implied vol on options that expire two days post earnings.

[00:13:52] That's not the highest reading we've seen, but it does say that there is a lot of wealth at risk.

[00:13:58] Taking risk over earnings is a unique exposure for the trader.

[00:14:01] He or she could be stuffed with very overpriced vol or might wind up shorting something that experiences a giant move leading to losses from gamma.

[00:14:11] The event-driven nature of earnings as well puts your side in the especially short asymmetry camp.

[00:14:17] Your client has studied this far more than you have and has initiated his friendly call to you based on that study.

[00:14:25] Our industry tends to categorize the vol traders as the quanti folks well-versed in Black Scholes probabilities and such.

[00:14:33] The fundamental accounts are less about options math but steeped in valuation metrics and industry dynamics of companies.

[00:14:39] I always thought that the best vol trader was a fundamental PM who had a strong grasp of how corporate fundamentals had implications for the distribution of stock prices and thus the price of options.

[00:14:51] I'm recalling one such trade in which a company reported awful earnings.

[00:14:55] The stock was cut in half and a client came in to sell more than a generous handful of downside puts at vols well north of 100.

[00:15:03] It may have looked okay on an implied to realize basis, but it was not premium well spent for my team.

[00:15:10] It's difficult to monetize 100 vol, especially when a business gets near a valuation floor where it's so cheap it could just be taken private.

[00:15:18] Folks, we have completed fully one half of the 20 things to do before you ask for a price.

[00:15:24] There's plenty more on the way.

[00:15:26] To summarize things 6 to 10, note whether the option is delta neutral or outright, check option market depth, check volume, see the options delta, and lastly, check earnings.

[00:15:37] Before I let you go, I want to visit the business rationale for these 20 things.

[00:15:42] As Gecko said to Sir Lawrence in Wall Street,

[00:15:44] My motivation, same as yours, Larry, money.

[00:15:47] I think this to-do list can play a role in bolstering the process in which the sales trader asks his or her trader to take risk.

[00:15:55] Repeated with consistency, the process will be imbued with trust.

[00:15:59] And when the trader trusts the salesperson, there are positive results coming, including empowering the trader to take more risk.

[00:16:06] And it also becomes highly evident to the client that there's a partnership between sales and trading.

[00:16:11] The perception that the transaction can be win-win, not always literally, but at least bought into on an ex-ante basis, underpins the interaction.

[00:16:21] And I'd argue most folks want to be part of a process that has win-win in mind.

[00:16:25] I've spouted on for plenty long enough.

[00:16:28] Next time we tackle some of the nitty-gritty of nuances and option orders like strike skew and term structure.

[00:16:34] Looking forward to that and wishing you a most excellent week.

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[00:16:46] As we aim to utilize these conversations to contribute to the investment community's understanding of risk,

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[00:17:01] Thanks again and catch you next time.