26th Annual Risk Management Conference

Fundamentals of Options: Part Two

The Role of Market-Makers

Joseph E. Bonin
 Agenda for this presentation
¾ The Role of Option Market-Makers
• Misconceptions and Conceptions
about Market-makers

• Delta-Neutral and Volatility Trading

-- A Market-Maker’s Perspective

• Position Risks: Delta, Gamma, Vega, Theta

-- and their Relevance to Investors

¾ Questions and Answers

March 16, 2010 1

 Options are often misunderstood

March 16, 2010 2

Market-Makers are often misunderstood

¾ It is you versus them (Texas Death Cage Match).

¾ Playing a zero sum game.

¾ They have better computers.

¾ Rocket scientists, everyone of them.

¾ They have an advantage over you.

March 16, 2010 3

 What do Market-Makers want ?

¾ To Make Money

¾ To Manage Risks

¾ To Avoid “Surprises”

¾ To Live Happily Ever After

March 16, 2010 4

 Trading versus Investing
¾ Who does what?

¾ How do they differ?

¾ Math(s)

¾ Hedging

¾ Understanding how other market

participants think.

March 16, 2010 5

 Risk

Options have several moving parts.

What will happen if there is a change in those things on

which an option’s value depends?

That’s “risk”.
Exposure to change.

March 16, 2010 6

 What’s in the Black(-Scholes) Box?

probability distribution

S
S
X Theoretical
Black-Scholes Value and
r
t
European Option
σ Call Option Risk
Measures
Valuation
Model

March 16, 2010 7

 Option Valuation C(S, X, r, t, σ)
DELTA: Measures the Option Value’s sensitivity
Δto changes in the Stock Price.
GAMMA: Measures the sensitivity of the option’s
Γ DELTA to changes in the Stock Price.
VEGA (TAU) : Measures the Option Value’s sensitivity
ν to changes in Volatility.
THETA: Measures the Option Value’s sensitivity
θ to the passage of Time.
RHO: Measures the Option Value’s sensitivity
ρto changes in Interest Rates.
March 16, 2010 8
Option Risk Measures: European 50 Call Example
Underlying: Non-Dividend Paying Stock:
(r = 4%, σ = 30%)
t = 3 days t = 90 days t = 360 days
50C = 0.00 50C = 1.12 50C = 4.16
Δ = .00 Δ = .29 Δ = .47
S = 45 Γ = .00 Γ = .05 Γ = .03
ν = .00 ν = .07 ν = .18
θ = .00 θ = .06 θ = .01
50C = 0.55 50C = 3.23 50C = 6.88
Δ = .51 Δ = .56 Δ = .61
S = 50 Γ = .29 Γ = .05 Γ = .03
ν = .02 ν = .09 ν = .19
θ = .11 θ = .08 θ = .01
50C = 5.02 50C = 6.61 50C = 10.23
Δ = .99 Δ = .78 Δ = .72
Γ = .00 Γ = .04 Γ = .02
S = 55
ν = .00 ν = .08 ν = .18
θ = .01 θ = .07 θ = .01

March 16, 2010 9

 Delta
¾ How a Market-Maker Thinks About Delta.

¾ Measure of how long or how short you are.

¾ This is the risk most Option Market-Makers try to avoid

like the plague.

¾ Why?

¾ Because you’re smarter than he or she is.

March 16, 2010 10

 Graphical Exposition (at expiration)

+ C (LONG) + P (SHORT)

- C (SHORT) - P (LONG)

March 16, 2010 11

 In reality, . . .
what options look like prior to expiration
Option
Value

+C

X = 40 Spot Price

March 16, 2010 12

 Options are “Curvy”.
Option
Value

+P

X = 40 Spot Price

March 16, 2010 13

 Long Call like long stock: How long are you?
Option
Value

+C

X = 40

Spot Price
S = 20 S = 40 S = 60

March 16, 2010 14

Delta: A measure of how long or how short you are

Option
Value
+C
ITM
Δ = .95

ATM
Δ = .50
OTM
Δ = .10 X = 40

Spot Price
S = 20 S = 40 S = 60

March 16, 2010 15

Option Delta changes as stock price moves: Gamma

Option
Value
+C

Δ = .95

Δ = .50

Δ = .10 X = 40

Spot Price
S = 20 S = 40 S = 60

March 16, 2010 16

 Delta as a hedge ratio
If a Trader buys 600 of the 40 Strike Calls (each option covering 100 shares),
that makes him “long”. He doesn’t want to be long; he doesn’t know where
stock will be trading tomorrow. What will he do? He will hedge his position.

Option
Value
+C

Δ = .50

X = 40

S = 40 Spot Price

March 16, 2010 17

 Delta as a hedge ratio
What is the Trader’s Δ (Delta)? How long does he perceive himself to be?
Long: 600 options x 100 shares x 50 delta (.50). Like he’s long 30,000 shares.
He will go out and sell 30,000 shares of the stock. He’ll be “Delta Neutral”.

Option
Value
- ΔS +C

Δ = .50

X = 40

S = 40 Spot Price

March 16, 2010 18

 Delta Neutral = Flat
Option -ΔS +C
Value

Δ = .50

X = 40

P/L S = 40 Spot Price

March 16, 2010 19

 What if the stock price goes up?
Option -ΔS +C
Value

} ++

}+
}-
P/L S = 40 Spot Price

} ++

March 16, 2010 20

 What if the stock price goes down?
Option -ΔS +C
Value

}+
}-
} ++

P/L Spot Price

S = 40

} ++

March 16, 2010 21

 So, what do the options guys do?
As the market moves, the Trader is becoming “unhedged”.
Is it good to be unhedged?

P/L

S0 = 40 S1 = 43

Spot Price

-3

March 16, 2010 22

 Getting long as the stock price moves up
Does the Trader want to be long? No.
How does he keep from being long?
Sells some more stock (at the higher price).

P/L

S0 = 40
S1 = 43

Spot Price

-3

March 16, 2010 23

 Rehedge the position
If, after rehedging, the stock price falls, now the Trader gets short.
Do you like to be short as the market falls?
How does he keep from being short?
Buy some Stock back (at the now lower price).

P/L

S0 = 40 = S2 S1 = 43 Spot Price

-3

March 16, 2010 24

 How do option guys make money?
If you ask the option market-makers what they do,
they will say we trade volatility.

P/L

S3 S0= S2
+ .10 S1 Spot Price

SEXP

-3

...

March 16, 2010 25

Long Put: long Gamma or short Gamma?

Option
Value

+P
ITM
+ ΔS
Δ = - .95

ATM
Δ = - .50
OTM
Δ = - .10

X = 40 Spot Price

March 16, 2010 26

Long Options Upward Curvature Long Gamma

+C +P

Once the Option is Hedged, … .

LONG GAMMA if you think the STOCK PRICE will be VOLATILE.

March 16, 2010 27

Short Options Downward Curvature Short Gamma

If you are SHORT OPTIONS, you are SHORT GAMMA.

-P -C

SHORT GAMMA if you think the STOCK PRICE will NOT be VOLATILE.

March 16, 2010 28

 Gamma
LONG GAMMA = LONG OPTIONS = WANT VOLATILITY.

P/L

S
- Option
Premium

SHORT GAMMA = SHORT OPTIONS = DO NOT WANT VOLATILITY.

P/L
+ Option
Premium S

March 16, 2010 29

 Long Gamma
¾ Looks too good to be true.

¾ Don’t try this at home!

¾ “Do not attempt. This was done by a

professional driver on a closed track.”

¾ Not a magic black box.

¾ No free lunch.

March 16, 2010 30

 Option Risk Measures
One of the nice features of Option Risk Measures is that they
are additive.

At the end of the day,

we have one IBM Delta and one S&P 500 Vega.

C (S, X, r, t,σ )
Δ (S, X, r, t, σ )
Γ (S, X, r, t,σ
σ

)
ν (S, X, r, t, σ )
θ (S, X, r, t,σ )
ρ (S, X, r, t,σ ) σ

March 16, 2010 31

 Delta Risk
¾ If you trade the hedge with your option market-
making counterparty, that is a risk he/she doesn’t
need to take.

¾ Doesn’t guarantee better pricing, but it may.

¾ Tied Trades

March 16, 2010 32

 Different Strokes
¾ Options are valued in a strange world (the “risk neutral”
world).

¾ As if you think a stock price will grow over time at the

risk free rate of interest.

¾ Absurd (but true), who would buy a stock that was

expected to grow at the risk free rate.

¾ Don’t fear the reaper (or option market-maker)!

March 16, 2010 33

 Are options zero-sum vehicles?
Can an option market-maker and his counterparty both win? Sure!

+C

Spot Price
(at expiration)

-C
And they could both lose, too!

March 16, 2010 34

 Volatility

¾ The formal definition of volatility (for the purpose of option

valuation) is the annualized standard deviation of
logarithmic price ratios.
¾ To be precise, option valuation models make assumptions
about the returns to an asset (not about prices or rates).
¾ Returns are generally assumed to be normally distributed;
the implication is that prices are assumed to be lognormally
distributed.
¾ What exactly is a “25 vol”?

March 16, 2010 35

Paraphrasing Potter Stewart, “… but I know it when I see it.”

price

time

March 16, 2010 36

 Intuitively
Consider a stock trading at S = $40
If its volatility is 25%, what does this mean?
This implies that there is a 2/3 chance that this stock will lie between
S = 31.15 and S = 51.36
(= 40 x e+(.25x1) ) in 1 year.
This implies there is a 95% chance that this stock will lie between
S = 24.26 and S = 65.95 in 1 year.
This implies that there is a 2/3 chance that this stock will lie between
S = 35.30 and 45.33 in 3 months (t = 1/4).
The “rule”: future S “boundaries” based on S x e+/- ( σ x Sq. Root(t)).

Worth noting, 3-month vol risk is half of 1-year vol risk.

March 16, 2010 37

 Volatility Risk
¾ Option market-makers often take on volatility
exposures.

¾ There are many reasons for this.

¾ There are many ways to handle this risk:

• Vertical Spreads (Call Spreads, Butterflies)
• Horizontal Spreads (Calendar/Time Spreads)
• Trading options in related product areas

March 16, 2010 38

 Other Risks
¾ Interest Rate Risk

¾ Dividend Risk

¾ Liquidity (in the Underlying Asset) Risk

¾ Market Gap Risk

¾ Regulatory, OCC, Legal, . . . Risks

¾ and more (like Pin Risk).

March 16, 2010 39

 Graphically just prior to expiration
Option
Value

+C

Δ = 1.00

Δ = .50
Δ=0
X = 40 Spot Price
S < 40 S = 40 S > 40

March 16, 2010 40

 Pin Risk
¾ At expiration, seems single stocks tend to trade at/around some strike.

¾ Given the number of strikes and the difference between strikes, it often
makes sense that stock will be trading close to some strike.

¾ One of the factors that can influence a stock being “pinned” is the open
interest (number of listed option contracts outstanding at that moment in
time) and proportion that is hedged.

¾ As we just saw market-makers hedge and re-hedge in an attempt

to profit from the movement in the underlying security.

¾ If the open interest is large, particularly in relationship to the average

daily volume of the underlying this hedging and re-hedging can dampen
volatility and “pin” the stock price around strike.

March 16, 2010 41

Pin Risk: From The Wall Street Journal (2009)

March 16, 2010 42

 Summary

¾ Room for everyone

¾ A difference of opinion is what makes markets work.

¾ Understanding how the other guy thinks

can help you in your investing/trading.

March 16, 2010 43

 Questions

March 16, 2010 44