the messiness of options in the real-world

Recently, I’ve been writing a lot about option funding — implied rates, reversal/conversions, and financing stock positions, and even a touch on early exercise. The posts from earliest to most recent:

• the easiest win in options is for stock traders
• implying the cost of carry in options
• what hides in the option chain
• the art of paranoia

You can’t really overstate how important this is, especially to pros.

On the same theme, Stanford lecturer and HF manager Kevin Mak published an outstanding and detailed post:

Holding a high cost to borrow stock? Here's how to collect the borrow fees using the options market (link)

I want to quote a few key parts:

I cannot stress enough that if you want to be competitive in capital markets, you cannot afford to make these types of mistakes and forgo this return.

Kevin is quite blunt:

If you think this is too complicated to follow, to be blunt, you likely do not have the mental fortitude to have alpha in markets (you may still make money via luck). If you CAN figure this out, but couldn’t be bothered to spend time on it, that’s probably fine, but I suggest staying away from holding a stock with a high cost to borrow. If you insist on holding high cost to borrow stocks, and "not worry" about collecting the free borrow/lending fees, you really should be playing triple-zero roulette, or splitting every pair of 10's at Caesar's Palace instead because that would have a lower edge, and be way more fun.

I suggest that by using options to refinance your position, you “inherit the market maker’s funding rates” which are almost certainly better than yours, whether you are long or short.

This is Kevin’s way of saying this which might land better for some (emphasis mine):

If this is arbitrage, it shouldn’t exist right? This unique situation is you “arbitraging” your own holdings. You’re basically holding an inefficient asset since you can’t lend it (or collect the lending fees) so this lets you own it in a more efficient manner. Nobody is going to compete away this arbitrage because nobody can access your holdings except you. In fact, it's the arbitrage happening in the open markets which is pushing the value of synthetic long to be equal to the long stock (and collect borrow) position.

Kevin wisely tucks all the brain damage into the endnotes to not ruin the flow and central message of the post. I love his intro to them:

This is a beginner treatise on a synthetic long position and covers ~98% of what you need to know about it. The last 2% I could write 25,000 words about and not be finished.

In the spirit of the endnotes, I want to share a recent real-world example of a scenario that resides in that annoying “2%”

Alex, a mutual of mine on X, asked the following:

I bought some deep itm $AIV calls, I think Jan exp, a couple weeks ago because I thought they were cheap vs my financing cost. Not much extrinsic value… Underlying had silly spike after hours, up then down.

Was the right way to trade this, to short the underlying after hours? I thought about exercising to sell, but didn't want to burn a few months of time value for nothing, even if I didn't really pay for it.

I’m going to step through the conversation, injecting meta-commentary to bring it down a level.

Me: Your trade expression was because of financing but you are asking about what you should have done with your delta. I'm not being pushy, I'm just trying to help you answer your own question.

There are 2 things I can see so far:

• Alex is conflating his strategic financing decision with tactical delta management. I do the Socrates thing as a habit when learners entangle multiple issues into a single question. If I just jump ahead and answer each part of the implied questions, I rob Alex of a valuable opportunity — to debug his own thinking by breaking the big question into its components. I notice many people getting option or trading concepts rolled into a ball of yarn, which tells me they don’t understand each string as well as they should. When you’re forced to decompose your own question, the deficiency is self-apparent.
• He's showing good instincts about not wanting to exercise the calls because he’d be “burning a few months of time value.”

💡Option Pricing Clarifications

1. The first [but not final] check on whether you should exercise a call is if the value of the OTM option on the strike is worth more or less than the cost of carry.
   1. For an ITM call, is the dividend you are exercising for worth more than the put on the same strike?
   2. For an ITM put, is the interest on the stock short if you exercise greater than the call on the same strike?
2. Alex said he thought about “exercising to sell,” but to be clear, you can’t exercise the calls after-hours and have it settle the next day. There is a cut-off for exercise notices. He would have needed to short the stock after hours, then exercise the next day, meaning he would have to carry a short for 1 day. This tactic would have flattened his delta, but he would have to incur any financing ramifications for the 1-day short.

This simple scenario highlights a risk to using heavily-discounted synthetic futures to express a long:

If you plan on liquidating the length before expiration, you are exposing yourself to the change in funding that you otherwise locked in.

In this case, Alex is exposed to the borrow he may have to pay on short shares if he chooses that route to cut length. One day’s borrow, even if steep, is unlikely to make or break the whole trade, but the bigger issue is the “locate”. There might not be any shares to borrow from your broker. If Alex was long the stock instead of the synthetic stock, he could just sell it in the after-market.

If Alex chooses to cut length by selling the ITM call, it may be for the same discount that attracted him to buying them in the first place. It’s like buying a home for a discount because it has lots of street noise. It’s a problem you can’t outrun because you will be on the losing end of the discount when you sell the house.*

*Tangential, but I see people misunderstand this in the private school vs public school debate. If you pay up to live in a good school district, you are exposed to 2 risks:

1. The carry cost on the premium. If you pay 20% more for a good school district, the funding cost on the extra ~20% of mortgage is the cost. If schools are the deciding factor between an $800k or $1mm house and mortgage rates are 5% then your pre-tax cost of the better schools is ~$10k per year. This is probably much less than private school tuition, especially if you have multiple kids.
2. The perception of school quality. The “school premium” can expand or contract over time. You can win or lose to this when you sell.

In general, the true cost of the premium you pay for good school districts is very small relative to private school tuition, making your VORP hurdle for private school choice high (although worth it for many people).