Jul

2

Within the "dark pool" of the market's ecosystem, there exist top feeders who like to provide bottom dwellers with 'insurance' policies. This "magnanimous" activity manifests itself in the provision of such products as options and more 'complex' structured products.

Clearly, as with all insurance policies, the seller of the policy has no intention to pay out upon the risk if it eventuates.

One noticeable element of these structures is the inability to get out of them in a timely fashion.

An examples should suffice:

In 2008 one was fortunate enough to have bought an AUD Put / JPY Call. As the AUD/JPY cross rate declined (and, for those who remember, Armageddon approached) not only was the 'delta' of the position increasing but the 'Vega' was too! A rare occurrence in option-land for TWO of the 'Greeks' to be in one's favour. At a time when I wanted to cut the position with a reasonable gain, the counter parties in the options market made a volatility spread so wide, that to have sold the structure back would have entailed losing money even though I had bought a low volatility and the spot had moved massively my way. To have simply bought back the delta and ridden it to expiry would have led to massive illusory PL swings because of the way options are revalued by the seller. The upshot is that I was unable to collect on the 'insurance policy'

Even in today's 'it can only go up/ prosaic times', market insurance policies are a scam.

Some things for speculators to consider:

1. Is there a level of volatility at which markets become 'untradable'? On the upside, I believe there is a level - or put differently, there is a quantifiable rate of change in the cost of insurance after which the spreads are impossible to deal at (In the above AUD/JPY example the volatility spread was 30% / 130% !!!!)

2. Is there a certain minimum level of volatility that the ecosystem requires? The answer might be different for different markets but overnight implied volatility in the major currencies hit the lowest in more than 20 years yesterday at circa. 5.5% annualised so who knows.

3. As alluded to above, should one watch the bid/offer spread on insurance as a predictor of bad/good times ahead. The magnitude of the spread in At The Money options markets certainly widens as the underlying approaches the point at which the big sellers might have to pay out thus making it hard or impossible to exit.

4. The amount of inbuilt spread in structured product in the street at the moment is genuinely appalling. But it is selling VERY WELL because large over regulated investors are being required by their 'consultants' to deliver 'stability' at all costs….. Not a single one of these structures is fit for purpose.

Lifting a line from EdSpec - '…..are there any words in the English language that mean 10000 times less than zero..' is a good way to explain the probability of the buyers of these products being made whole if the worst happens.

Jordan Neuman writes: 

It is a fear I share when I buy out of the money puts. I recently corresponded with OCC about their "Doomsday" procedures and found out they don't really have anything concrete. How do you plan for option settlements under total chaos? And I do remember the 30%+ spreads on plain vanilla S&P options in the fall of '08.

I recall in the original Market Wizards Jim Rogers advised shorting Japan but said that while you might be able to get some money out on the initial decline, if you wait until the ultimate collapse you won't.

Ed Stewart writes: 

Awesome post with much food for thought.

For the health of the market I would think that two environments are critical -environments that best feed market makers, and environments that most encourage commercial participation. If a market becomes too stable there is less need for commercial hedging, less transactions for market makers, and the range for speculative profit to profit dries up. I see it as speculators "crossing the bridge" between commercial buyers and sellers - the profit incentives motivate us to find ways of doing this. If the path is too short we can't make any money to cover costs.

A notion that I like is that the best speculative markets are where commercial interests have just been pushed to their uncle point in terms of pricing - at that point there is a very strong need for speculators and certain premiums develop - one can see this dynamic if you read the reports of (for example) commodity processors after a large price move.

Also which side of the trade is weak (buyer or seller) might depend upon who is on which side is the speculator vs. the house, or alternatively which side can take delivery vs. the side that needs to offset over a certain time horizon. The edge to the first party grows as (say) first notice approaches.


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