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Options Trading as a Game

Mike Lipkin

QuantCongress Europ


Options Market-Making on an
Exchange Floor
Reality, NOT Theory
Mike Lipkin,

Mike Lipkin

American Stock Exchange and
Katama Trading, LLC

QuantCongress Europ


Mike Lipkin

QuantCongress Europ


Mike Lipkin QuantCongress Europ 4 .

often by suppressing time-variations at these frequencies. Nevertheless: Economists (especially). but it does not reflect the reality of exchange trading. Physicists. have attempted to model what prices are seen on the screen. etc. Financial Mathematicians.Dynamics: Everything on the Screen is time-varying at highfrequency. Mike Lipkin QuantCongress Europ 5 . This is not unreasonable.

no highfrequency dynamics (thermodynamics) B*) A far-from-equilibrium state C*) A dynamical steady-state D†) A game board between moves *-dynamics to be supplied †-rules for moves to be supplied Mike Lipkin QuantCongress Europ 6 .Four Possible Model Types for Screen Representation: A) An equilibrium (read arbitrage-free) state.

the option price will be unchanged as t0.Black-Scholes. Stock prices move randomly according to the underlying (perhaps Brownian) process. Mike Lipkin QuantCongress Europ 7 . (CEV.…) belong to the first class a) b) c) Options have unique prices that change continuously with time (although stock prices may be subject to deltafunction impulses: Brownian motion or even jumps). Markets are frictionless so transaction costs may be ignored. If the stock price is unchanged. with usually a drift bias provided by the risk-free rate.. VG. et al.

BUT: e) Option valuation is independent of other factors especially (but not limited to) supply and demand for options and stock. Mike Lipkin QuantCongress Europ 8 .d) A consistent valuation of option prices needs the underlying variables of the stock process: interest rates. dividend dates and amounts. volatility or standard deviation of the stock price movement. etc.

all these conditions are violated.In actual floor and screen trading. t= tnow Mike Lipkin tchar texp- QuantCongress Europ texp 9 .

Market-Maker as Maxwell’s Demon “Sell 300 May 50’s at $1.80” Mike Lipkin QuantCongress Europ 10 .

we concentrate on XYZ Nov 50 calls for the next several slides. Into the Trenches…. As an example. Mike Lipkin QuantCongress Europ 11 .Real Options Pricing is Path-Dependent.

60 (200x200) Scenario A: 10:03:00 initial market 10:03:30 “Buy 50 calls at the market” 10:04:00 “Sell 50 calls at $1.50” 10:04:00 “Buy 50 calls at the market” Mike Lipkin QuantCongress Europ 12 .XYZ Nov 50 C 1.40 1.50” Scenario B: 10:03:00 initial market 10:03:30 “Sell 50 calls at $1.

60 1.45 1.50 10:03:00 :29 :30 :31 10:04:00 1.Time-line for the two scenarios: A: B: Mike Lipkin 1.50 1.50 1.50 1.50 1.50 1.50 QuantCongress Europ 13 .45 1.

500-up. Specialist: 1.60 32.Response to SIZE trading: XYZ: 32. 1. 500 more at 1. there’s 500 more at 1. Mike Lipkin QuantCongress Europ 14 . I’ll try to get those.30-1.60. the ISE is at 1.70 away.70. I’ll try to clear the away market….75.70. 1000-up Broker: I’ll pay up to $1.60.40-1.80 for 5000! --Specialist: You bought 500 at 1. size market.70.70 (400x750) Broker: Nov 50 calls.I only bought 100 at 1.

$1. Traders: Sell 100. Sell 100. Sell 50. The new market reads: Nov 50C 1.Size trading continued… Suppose that a lot of stock is available at $32.80 1. When all are done (and the away markets are cleared) the broker still is bidding for 800.70 (unlikely!!) Specialist: How many have you done so far (through $1.95 (800x500) Mike Lipkin QuantCongress Europ 15 . Some traders have an oversupply of premium. etc.75)? Broker: 3500.80 bid for 1500.

LEANING: Mike Lipkin QuantCongress Europ 16 .

So far he has bought 84. HOW MUCH STOCK HAS THE CROWD BOUGHT? A LOT.000. maybe 125.000!! Mike Lipkin QuantCongress Europ 17 . The broker has bid for 100.70 might be 20.An estimate of the deltas for the XYZ Nov 50 calls with the stock at $32.000 deltas.

Nov 50 calls were worth $1. So without the stock moving the price has increased by 30¢.80+.VALUATION: During all this flurry of trading. When trading began. the market-makers are adjusting the theoretical valuations of the options.50. Mike Lipkin QuantCongress Europ 18 . They plug the trading price of the option into a model and arrive at a volatility. WHY? Because traders don’t input the measured stock volatility of a model and get a price. now they are valued at $1.

40 Trader: Feb 40 puts. You bought them. This is all heuristic. seat-of-the-pants fiddling.Valuation continued… A trader in the crowd has increased the volatility he uses for Nov 50 options by 10 clicks. Mike Lipkin QuantCongress Europ 19 . When he does this. Feb 40 P 14 14. it turns out that the Feb 45 puts have a new theoretical value. Originally he thought the puts were worth $14. He raises the Dec options on the 50 line by 5 points and the 45’s and 50’s by 3 points. 14.40 for 50 Specialist: 32 there.34.

Without hearing what order the broker has. buying calls and stock.25.Valuation continued… Later in the day the stock is trading 35. With nothing on the book the market reads: Nov 50 C 2.85 (200x200) Trader A is short 500 deltas. The same broker enters the crowd and asks for the market.65-2.65 2. selling puts. Specialist: 2. he immediately tries to buy deltas.85 200-up Broker: Where do 500 come? Mike Lipkin QuantCongress Europ 20 .

cont… What is the role of an equilibrium model? Once the new prices are stable. Mike Lipkin QuantCongress Europ 21 . calendars and verticals are priced off the standard models.Valuation.

2005. a BA customer sold 150.000 FDC Jan 40 calls to market-makers. The implied volatility went from 23 to 19 in January and from 28 to 20 in November.* * at-the-money options Mike Lipkin QuantCongress Europ 22 . mostly within a two-hour window.Real World Example: • • On September 16.

That is RISK. But there is another powerful effect.RISK: So supply and demand is the principle reason for marketmakers to change their valuations. Mike Lipkin QuantCongress Europ 23 . which is a direct consequence of Options Trading as Games Playing. Strong effect on tail valuation.

sale of apartment.000 Down 25% he makes $80.75 Up 25% he loses $900.000 (volatilities unchanged for this simple example) -900K = visit to unemployment.Scenario Consider a trader with the following risk profile: Stock ZYX at 65. etc… Mike Lipkin QuantCongress Europ 24 .

Others in Crowd: sell 30. the trader may be buying on several markets electronically. cont… ZYX Oct 80 C 0.90 1. 1. Trader: I bought 90.98.05 bid for the balance. 1 bid for 500. Mike Lipkin QuantCongress Europ 25 .05 (200x200) Naïve valuation is $0. Trader: ZYX Oct 80 calls.Risk Scenario. sell 25…. In practice.

Risk. cont… Many factors contribute to the net safety of a trader’s position: a) b) c) d) e) Net calls Net puts Vega Dividend/interest rate Decay Mike Lipkin QuantCongress Europ 26 .

Risk. cont… These concerns can be rewritten in more suggestive terms. Some risk factors are: a) too short premium (blow out risk for big moves) b) too long premium (decay risk for small movements and contraction risk for steady up moves) c) volatility risk (especially long term contracts) d) interest rates e) take-over risk f) hard-to-borrow (buy-in risk) Mike Lipkin QuantCongress Europ 27 .

The 50 strike is the highest strike available.5 Dec 40C 3.75 Apr 50C 4.75 Apr 40C 5.25 Oct 40C 2.25 Dec 50C 2.5 Dec 30C 8. the order flow in the Apr 50 calls becomes brisk and one-way. All of a sudden. Can you guess which way? Mike Lipkin QuantCongress Europ 28 .5 Apr 30C 11.85 Oct 50C 1.Takeovers (An abbreviated option board:) Oct 30C 6.80 XYZ is trading 30 at the end of September.

What market does he get? Mike Lipkin QuantCongress Europ 29 .50. Sell 500… No one consults a theory. The implied volatility on all the 50 lines gets crushed. At the same time orders come in for strange spreads: Broker: Give me a market in the Oct 30-40 1-by-2.Takeovers. cont… Brokers (or electronically): Sell 200. The screen value is $1. Sell 300. the volatility in the late months gets reduced.

Takeovers. 232(13)= -3. Mike Lipkin QuantCongress Europ 30 . the 40 calls make $13. less than they are now! The 1x2. The order flow has told us.25 500-up. cont… Specialist: . What would you rather do? Buy or sell the 1x2? What if XYZ is acquired for $53 in cash? The premium on the options will all fall to near $0! The Apr 50 calls will be worth $3. The 30 calls make $23.80-1. Anyone buying the 1x2 loses $3 on the spread PLUS what he paid for it. We don’t have to prove to the SEC that people know a deal is imminent.

2004 Mar 20 53 vol. Sep 30 32 vol. Mar 22.5 58 vol.EDS after takeover rumors began 4 March. Mike Lipkin QuantCongress Europ 31 .

Mike Lipkin QuantCongress Europ 32 . theory second. • The perception and reality of risk changes the values paid for options independent of order flow. • Hysteresis is real in option prices. Implied volatilities depend greatly on the recent stock path. • Game theory and/or the physics of driven dynamical systems may provide a better approach to market analysis. • Possible BIG IDEA: takeovers instead of defaults.Conclusion and Summary • Option prices on the floor are determined by supply and demand first.

15% of their profits (nearly half on AMEX). • GS tried to automate (read: apply thermodynamics) to options specialist book.The Real World • Goldman Sachs paid US $7B for Spear Leads and Kellogg (2001). • GS sells AMEX book back to original SLK partners for US $11M (2004). Conclusion: Profits come from Arbitrage not Equilibrium. • SLK option market-making accounted for ca. Mike Lipkin QuantCongress Europ 33 .