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15 Sep, 26 tweets, 6 min read
Option Market Anomalies (Thread)

In July, single stock options volume exceeded share volume for 1st time ever. Add to that all the index options and you’ve got a situation where the tail is wagging the dog.

via ⁦@zerohedge
This is a significant event that deserves close attention.

Options theory assumes that the actions of the option trader don’t affect the underlying. Given banks delta hedging of options risk, this is clearly not true.
However, if the scale of options trading is small relative to that in the underlying, like it has been historically, the assumption is largely true. Funky things happen when these oft forgotten assumptions underlying the market are violated.

Let me give you an example.
In the early 90’s, I remember a client asking us for a bid on a $200m call on a Canadian way off the run short bond. Unlike today, back then, because of Fed activity, short rates were volatile. Canadian rates were more volatile than those in the US.
This being an off the run meant it was even more volatile than the benchmark. The entire issue was only $1.1b in size. Given the small size of the issue and its off the run status, it didn’t trade continuously. It gapped.
I figured that owning a good chunk of a small issue would give me effective control, so rather than fading my price for the relatively large size (18% of the issue), I bid up for it. Not surprisingly, we won. I was young and cocky figuring I was a total genius buying this thing.
It was going to be a money machine.

Things started out well, but then something started to go wrong. One morning, the market shot up violently, I put up a cheap offer to get the party started. But, rather than getting lifted immediately, someone offered lower.
It didn’t feel right. Every time, I’d put in a bid or offer someone would step in front of me. Frustrated, I told my bond broker we needed to go out for a drink. I asked him, was it one guy stepping in front, or a bunch of people. He said it was just one. I asked him who.
He said he couldn’t tell me. He said it was weird. It was an off-off-off the run issue that just didn’t trade. Then suddenly last week, the issue sprung to life, but it wasn’t dealers short desks trading it. It was guys like me. A derivatives trader.
We were always the outsiders in the bond market. Did I know him, I asked. He said, very well. I had to know. So, I pressured him further. He wrote a common abbreviation for a first name on his napkin, turned it over and slid it to me. He got up, said good night and left.
I flipped over the napkin. It was my buddy, the options trader at the bank across the road.

Why was he stepping in front of me? He must have done the same trade. I didn’t get quite the exclusive deal I thought I was getting. Soon, that one issue froze. Yields went up and down.
It was pandemonium. Yet the bond I was long was stuck. I ask my bond broker who else was involved. He said it was just guys like me. How many, I asked. All five of you. We were the rates options traders of the five Canadian chartered banks.
We were stepping in front of each other so much, this bond never moved. Though the market was moving 30bps a day, this bond never moved. My dream trade had turned into a nightmare.
The client had used the violation of the principle that option trading doesn’t affect the underlying against us by making us fight each other. Between us, we had eliminated the very volatility we has paid for.

My boss asked why I was losing so much money. I explained.
He didn’t care. He wanted it to stop and was really pissed that some client had outsmarted the street.

That’s what happens when the options volume exceeds that in the underlying. That’s exactly what the client counted on. But, that’s not the way it ended.
In speaking to his counterparts, my boss found out that the options desks of all the other banks were hurting too. He asked me how I’d do if my position was $1b but no one else had it. I told him, I’d make a killing.

He suggested I approach my counterparts and buy them out.
First two paid me money vs the mark to take it off their hands. 3rd wanted mid. Done. 4th figured out my game and wanted more. I told him he risked screwing himself. A week went by. My losses were mounting, but my boss hung by me.
The heads of the 3 other banks were happy to have gotten rid of the dog. The head of the desk of the 4th bank was ready to kill his options trader. The trader called and said he’d sell it my price. I told him I wasn’t there. He asked where I was. I showed him a price way back.
He told me there had to be mistake. I told him that was my price and he could leave it if he didn’t like it.
I thought he was going to cry. I told him I’d show him mid for a yes or no. He said yours even before I got the price out.
I now owned a call on $1b of a $1.1b issue. No one would touch this orphaned bond.
I started driving the price down. The puzzled client asked what’s going on. Everyone told him they were out. He asked me. I told him it felt like others had the same trade. Silence.
The client who was long this bond had found a way to pocket the premium and dump his bonds on us. When the price started plummeting, he began dumping the bonds. I was the only buyer. Once I bought a few hundred million, I began to march up the price of the bond.
On days the market was up, this was up more. When the market was down, this was up. At first he kept selling. I bought, selling BA (like ED) futures against it to keep my rate risk in line. Riding on the rally in futures, I kept buying.
Because of his sales earlier on, and his outstanding calls, he began to buy. It was wild. Some mornings, I’d start the bid 10 points higher than last night. On the way up, I sold out some of my longs, but I still held $300m at the end.
On expiry, we exercised our call giving us $1.3b of a $1.1b issue. Delivery kept failing. Slowly, we’d put out a bond here or there. Sometimes, it would get lifted before the price made the screen. We came out just fine though we had to hold the bonds till maturity.
When the basic set of assumptions on which the market is based are violated, funky things happen. Gentlemen, strap on your seat belts.

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