the art of paranoia

This is a fun one.

A good friend and mentor from the pit sent me this (lightly edited and hyperlinked):

I was catching up on moontowers and reading your cotton story. Made me think of one that you can use if you ever cover interest rates.

I started in trading with silver options. I was quite meek as I had never clerked. I was just backed and thrown in the pit at age 22. Anyway, a couple of years in, silver had rallied from around $4 to $7. The whole pit was short long dated $4.50 calls to a spec who was holding the long. These things were easily exercisable as interest rates were high. Great short to have.

Broker [badge redacted] (you may remember him) offered the synthetic put at zero. No one knew what he was doing. I bid 2 ticks under and he said sold.

So I said “1000”. I think the biggest trade in that pit was like 200.

Anyway I took 1000, exercised them and made 10 grand before commissions. The carry was probably north of 50 ticks and he increased his shorts by around 800 as all the other locals got hit with my exercises. The other locals were pissed.

So I came in through a broker and bid 2 ticks under the next day. Locals hit me. I got lucky because I was clearing [redacted prime broker] and they neglected to put in my exercise. They delayed it by mistake (and gave me the interest as I recall.)

Anyway the locals thought they found someone who would hold these things and just wanted a synthetic put for a credit. I kept doing the trade for a week.

[Redacted broker] got it right by the second day. I think I made another 5 or 10 grand before the locals figured it out and stopped doing it.

Anyway. I hope if you relay this no former silver option traders subscribe. They still don't know it was me!

There’s a lot going on here!

Option pricing mechanics, pit dynamics, deduction.

Let’s start with the option pricing.

I don’t want to deny you the opportunity to figure that part out for yourself.

In the following list, I’ll start with important clarifications but as the list unfolds the material is more of a hint than just reference information.

Like a quiz show, buzz when you understand why “locals” [ie the other traders] were willing to” sell 2 cents under” and why my friend was willing to buy that level.

Clarification and hints…

• 1 silver option references 1 silver future. This is typical in commodities whereas equity traders are used to an option having a multiplier of 100
• 1 silver future references 5,000 troy ounces of silver. So if silver is $10 an oz, it’s a $50,000 contract
• The minimum increment, or “tick”, in silver options is .001 or 1/10th of penny. Since it references a 5,000 oz contract, a penny is worth $50 and a tick is worth $5.
• This story happened many years ago. Look at those silver prices: “Silver had rallied from around $4 to $7. The whole pit was short long dated $4.50 calls to a spec who was holding the long.”
• Silver options are American-style meaning you can exercise them anytime.
• “Random assignment”: when an option is exercised, any contract in that series held short is equally likely to be assigned regardless of the clearing firm or account. See rules.
• When a broker quotes a “synthetic put” (and yes synthetics are not just identities but directly traded orders!) the convention is to bid or offer as a “differential to intrinsic value”. When my friend bid “2 ticks under”, it’s understood that he’s willing to pay 2 ticks under “intrinsic value”. If the futures are $7 and the broker sells the $4.50 call 2 ticks under than the trade package is:
  • broker sells the $4.50 call at $2.498 to my friend
  • brokers buys the future for $7.00 from my friend
  • Make sure you understand this: to buy a synthetic put it to buy call and sell the future “1-to-1” (meaning for every option you buy, you sell 1 future.) Another way to express that is you hedge on a 100 delta. A synthetic put is assumed by everyone to be a simultaneous package of “long call, short future” in the same way as a straddle is call + put on the same strike or strangle is call + put on different strikes. “Synthetic put” is a real tradeable thing not just the name for an option identity.
• While futures are subject to initial and maintenance margin, option premiums are settled in full. In other words, the premium is not itself marginable. That is normal but worth stating because there are some option markets where the premium is marginable (ie WTI options on ICE)

At this point, you should be able to understand my friend’s side of the trade. If you don’t want to bother, stick around, I’ll spell it out soon enough but also that part should feel really obvious to anyone that’s ever owned an American option.

The harder question is:

Why were the broker and the other locals willing to sell him the synthetic put 2 ticks under?

Your last hint is a line already tucked into the story:

The whole pit was short long dated $4.50 calls to a spec who was holding the long. These things were easily exercisable as interest rates were high. Great short to have.

This is fun stuff. Let’s unpack it.

Why did my friend buy the synthetic put 2 ticks under?

It’s an American-style option. He buys the $4.50 call for $2.498 and sells the future at $7.00.

He exercises the call immediately, effectively paying $6.998 closing out the future he sold at $7.00. He makes 2 ticks or $10 actual dollars x 1,000 contracts. $10k profit (before exchange fees which probably claimed ~ 25% of that). Call it $7,500 for a minute’s work and no risk.

How could my friend’s buy be so good if he also says:

The whole pit was short long dated $4.50 calls to a spec who was holding the long. These things were easily exercisable as interest rates were high. Great short to have.

The key:

The carry was probably north of 50 ticks

50 ticks = 5 cents

In other words, the interest on $2.50 of intrinsic option premium was 5 cents or about 2%

💡While a market-maker will be hedged with futures, you only need to post margin to maintain that leg. You can satisfy the collateral requirement with T-Bills, so you really are capturing the the interest on the short option premium without having it offset by hedge funding which is close to zero.

💡In the story, there’s 5 cents of carry. If we knew the DTE, we could back out the interest rate prevailing back then. If we knew the interest rate, we could back out the DTE. But we have neither. We just have the recollection that the call had about 50 ticks of carry.

Think of the typical local’s position:

The whole pit was short long dated $4.50 calls to a spec who was holding the long.

The locals are hedged. They are short the deep in-the-money calls and long futures against them on a 100 delta. In other words, they are short synthetic puts. The puts on that strike are worthless however if the spec never exercises the calls, the locals will get about 50 ticks of interest. It’s like selling a worthless put for a nickel.

💡If you’re so Taleb-pilled you can’t imagine a put being worthless, just pretend you could buy the actual $4.50 put for a tick or the $4.75 put for 3 ticks. There’s such a thing as arbitrage bounds. Options 101 stuff.

Amateurs will say things like “that’s worthless” because they believe a price “can’t get there” but when I say it’s worthless I mean by arbitrage. Like the value of the put on that strike is dominated in such a way that if you could sell it at a positive value there’s free money on the board. An option trader thinks in a matrix of arbitrage relationships when they examine a chain.

You can see why the locals were willing to sell the put 2 ticks under. They didn’t think they would get assigned! They assumed they were going to collect 50 ticks on a riskless position.

The mistake was in thinking my friend wouldn’t exercise the calls. Perhaps they thought he needed to cover risk and if they were all short the calls he was just closing. But that doesn’t make sense to me since he was a “meek” trader before then and certainly wouldn’t have been short 1000 calls.

That’s the most puzzling part to me. I understand why they might believe a customer like the spec would not exercise the call optimally, but when a market-maker buys them you need to update. “This guy who trades options all day is buying an American-style option below intrinsic, I wonder what he’s going to do?”

I don’t want to be too snarky because “street smart” is probably one of the most salient features of a pit trader. I’ll assume I’m missing a detail that makes their decision justifiable.

The rude awakening

“The other locals got hit with my exercises. The other locals were pissed.”

This is the random assignment. When my friend exercised his calls the free interest gravy train slowed down as suddenly some of the locals got assigned which closed their positions (the short call goes away and the long future they were hedged with is liquidated to the exerciser).

💡In random assignment, you “expect” to be assigned on your pro-rata portion of the OI held by all shorts. How many you actually get assigned on can vary from this theoretical expectation because the sequential 1 by 1 assignment process is memoryless just like dealing from a deck of cards with replacement each time. Just because you got tagged on the last one doesn’t change your odds of getting tagged on the next one.

Let’s keep unpacking the story.

Poisoning the well

My friend masked his behavior to blend in with customers and used a broker to “bid 2 ticks under” the next day. The locals didn’t think it was a market-maker going through a broker. The locals were reasonable in not suspecting a local to be hiding themselves behind a broker order for 2 reasons:

1. Paying commission which would eat into the slim margin even further.
2. This behavior is known as “poisoning the well”. This type of pro vs pro crime was considered bad form. Just like in poker how the pros try to avoid each other and just eat the fish. Of course from the outside, the norm is considered anti-competitive.

Let’s address both of these.

Regarding #1:

My friend may have worked out a deal with the broker. After all, the broker stands to make a thousand bucks or so for no real effort and if the order is contingent on a reduced commission rate they’ll probably go for it.

[I used to do this all the time. Wet the brokers’ beak. We like to talk about nerd stuff and math here, but trading is a business like any other business. Giving out orders is currency. Traders who pay lots of commission magically get the first call. Whether it’s commodities or equities brokers can solicit the other side rather than bring an order to the pit and instead just cross it without worrying about the order being broken up (ie bettered) they can double-bill. Brokers are fiduciaries and their business is competitive, get too many bad fills and you risk losing a customer, but there’s a lot of leeway in discretion. I’m using a broad brush, the rules and details vary across asset classes, but the mechanics rhyme everywhere.]

Regarding #2:

Prisoner’s dilemma.

How much is it worth to defect?

Will we return to stasis and you got away with one or did you really poison the well?

Will anyone find out?

Does any of this change if you don’t really fit in with the club and can’t hope to be part of it?

And then there’s pure disagreeability mixed with self-confidence. I was at Max’s soccer game last weekend and the ref in a moment of deprecating humor said “They told me when I was a kid you need to either be smart or likeable. And I’m definitely not smart". I don’t think this particular buddy ever cared about going along to get along. But he’s also super-smart.

I’ll add my own perspective to the game theory stuff. I did nothing but watch markets get tighter, more competitive and more ruthless over time. The edge you never would have settled for becomes something you’d kick grandma down the stairs for before you know it. Someone is going to defect.*

This is chained to another observation. In a landscape where there’s excess profit (ie too much reward per unit if risk) there is always someone sandbaggin’. They aren’t showing how smart or fast they are because they will harvest at this level before it tightens and not have to tip off to others what’s possible. I know this firsthand because of a friend that runs a brilliant trading operation in a niche space in which he never shows the market how fast he really is. Imagine my lack of surprise when I read about this “don’t show” tactic from HFT-er Liquidity Goblin’s Let’s Pretend We Have An Edge (paywalled).

A fortunate mistake

I got lucky because I was clearing [redacted prime broker] and they neglected to put in my exercise. They delayed it by mistake (and gave me the interest as I recall.)

Anyway the locals thought they found someone who would hold these things and just wanted a synthetic put for a credit. I kept doing the trade for a week.

[Redacted broker] got it right by the second day. I think I made another 5 or 10 grand before the locals figured it out and stopped doing it.

My friend was able to milk the ruse for a bit longer because of an error! The prime broker failed to process the exercise which reassured the locals briefly that they were not getting picked off. Sounds like it gave him at least another day to buy more synthetic puts for a credit before the locals got wise to the game.

Knowing is half the battle

Let’s put a bow on this like an 80s cartoon ending lesson.

Being short those synthetics to a single counterparty who doesn’t realize the calls should be exercised is good fortune. But once someone wants to buy those deep ITM calls opening, you know that they know what they’re doing.

I’ll tell you from personal experience that anytime someone wants to trade a deep option or a reversal/conversion where there is little or no open interest your guard goes up. You check your funding assumptions. You think harder about what your option model is saying about the value of an American vs European style rev/con. The difference between the 2 represents the value of the early exercise option for that strike. Those are modeled via trees simulations and difficult to debug as opposed to closed form equations for European Black-Scholes.

Only the paranoid survive.

*I refer you to this excerpt from A Former Market Maker’s Perception of PFOF:

SIG wasn’t know as the “evil empire” on the Amex just because of the black jackets we wore. They understood the risk-reward was completely outsized to what it should be 25 years ago. They were amongst the first to tighten markets to steal market share. They accepted slightly worse risk-reward per trade but for way more absolute dollars. They then used the cash to scale more broadly. This allowed them to “get a look on everything”. Which means you can price and hedge even tighter. Which means you can re-invest at a yet faster rate. Now you are blowing away less coordinated competitors who were quite content to earn their hundreds of percent a year and retire early once the markets got too tight for them to compete.

SIG was playing the long game. The parallels to big tech write themselves. A few firms who bet big on the right markets start printing cash. This kicks off the flywheel:

Provide better product –> increase market share –> harvest proprietary data. Circle back to start.

The lead over your competitors compounds. Competitors die off. They call you a monopoly.