Dazed and Confused

Back in October of 1987 I was making markets in the Eurodollar options pit at the Chicago Merc.
To go through a market crash of that magnitude was an incredible experience. People "blew out", were forcibly removed from the trading floor (just like on Trading Places--"turn on those machines...."). But also, people made so much money, some of them retired in their 20s, and were never heard from again.

I was not trading S&Ps at the time. Rather, I was trading options on Eurodollar futures. A Eurodollar CD (as opposed to a yankee CD) is a dollar denominated 90 day discount instrument that is deposited in a foreign bank (normally a London bank). And of course, the Eurodollar futures contract is a promise to make or take delivery of a 1 million dollar CD. And an option is the promise, not the obligation to make or take delivery of these futures contracts. It all sounds rather confusing, but are very straightforward concepts once you've dealt in them.

The notion of what caused the crash is not important to a trader. What is important is how a person responds to the markets in a reactive and proactive way. The trader is reactive by anticipating, but proactive by keeeping risk/rewards at their optimal levels. In the case of the Euros, the locals in that pit had all made bloody fortunes being "premium sellers". But with the S&Ps being down 8,000 ponts the day of the crash, one had to assume a BIG flight to quality in the short end of the yield curve. And in that respect, money was there for the taking, just by properly butterflying your position and properly managing the position "legs". (More Tomorrow)

I was sort of shocked to see that 135 South LaSalle had a big fire on two floors. Not only do I bank at LaSalle Bank, but I know some of the principals involved. Norman Bobbins and his family were members of Bryn Mawr CC, where I used to lifeguard. I gave his son swimming lessons.

I have done projects for ABN AMRO, the parent company of LaSalle. So, I've spent tons of time at the building.

135 is a beautiful old Art Deco building and the lobby is so palatial, you expect Ginger Rogers and Fred Astaire to dance by when you walk through. The building was built by Marshall Field (who primarily made his money in real estate).

People often freak out when they have on a complex options position and the "sky is falling". Let's say that you have on a few hundred options in strangles. The market has moved substantially and you want to take profits. Or, you are losing because you are on the short side. --But, you can't get a decent quote out of the market.

How can you take some quick profits or cover the trade? One way to do this might be to work the "box". Your strangle puts plus strangle calls have coordinate deltas. That is, if your call delta is now 40, your coordinate put delta will correspondingly be -60.
And the net delta of a box is: -60 + 60 + 40 + -40.
This is the equivalent of a synthetic long future and a synthetic short future. Or, it is a reversal plus a conversion.

By putting on the box, you effectively 'lock' the position until expiration. Your risk is only that your short in the money option gets exercised. But the exerise is automatic and you receive a short or long future into your account.

Note that this does NOT work for non-futures options. Put call parity is not exact and corresponding deltas do not offset in non futures options contracts.

So, the markets have been quiet for a session and unemployment statistics are about to be released. The markets trade in a range and are nervous about the release. Everyone is expecting a big move, and volatility has been on the increase for days.

Let's say that right now the long bond market is trading right at a strike price, 112. There are 56 days to futures options expriation and volatility is trading in the 13% range, up from 10%. Open interest is jumping and the public seems to be buying up lots of puts and calls.

So the number is released on Unemployment Friday. Given the last release, Non farm payrolls were far lower than expected. And the market moved in exactly the opposite way than expected, up instead of down.

The net delta of the at the money straddle is about 0. But when such a trade is purchased, it is anticipated that long deltas will be "created" on the upside at an increasing rate and short deltas will be created on the downside at an increasing rate. The delta is the approximate rate of change with respect to the underlying asset or liability. The rate of change at which the delta changes is called the net position "gamma". If the first partial derivative is the rate of change of an options price with respect to the underlying price is the delta, the second partial rate of change of that options price is the gamma.

The public is often suckered into buying such positions like straddles or strangles when antipating a big move in the market. But those who do so have tended to forget the adage, "buy the rumour, sell the fact". Even though someone might have purchased some bond options at a net straddle price of 1 4/64ths, that straddle may actually break even or lose money after the move! Why?

Because another sensitivity that people often forget about is called the vega, the rate of change of an options price with respect to volatility. After a big movem, the pit and instiututions will sell off premium, In addition, options are wasting assets. On a Friday, the pit will often, by the end of the trading session start trading the opeions as if they are pricing them on Monday morning! I've seen vol drop as much as 5% while a release is actually going on!

Take a look at the folllowing options pricing primer. The Black model (1976) correctly prices a futures contract in a Brownian Motion, reflecting a lognormal distribution. However the difference between a forward price and a futures price refects the daily margin account adjustment, forwards only expire at the end of a term.

http://riskglossary.com/articles/black_1976.htm