### TRUMPISTI! Italian Populists Expected to Defeat Referendum; EU Crisis Looms

This could be the beginning of the end of the EU.

by Tyler Durden

Apr 19, 2011 4:38 PM

*From Vince Lanci of FMX Connect*

**Options Risk, Manipulation, and the May Silver $40 Calls**

*The purpose of this series is to help the
reader better understand the risks and pitfalls of trading options and
having a position at expiration. We will try to describe exactly what
happens at expiration. The concepts here apply to all options markets,
but we chose to focus on Silver because an interesting expiration is
setting up presently. The upcoming expiry gives us an opportunity to
discuss all the pieces of the option puzzle: the Greeks, market
manipulation, Pin risk, and other factors. *

**Lesson #1 **

In

futures markets where major participants are absent, options players

dictate market movement for short periods of time. During this time the

market may flat line, or it may have large, impulsive moves in either

direction. What happens is determined by the strong-handed player, and

sometimes his inclination to “game” the market.

**
**

** **

**The Easter Egg **

Observe if you will, the 6 days prior to expiration of Comex May Silver options.

April 21^{st}, Holy Thursday: day before a holiday^{ }

April 22^{nd}: Good Friday: CME Closed

April 23^{rd},Easter Saturday: Markets Closed

April 24^{th},Easter Sunday: Markets Closed

April 25^{th}, Easter Monday: LME Closed (Largest Physical Bullion Exchange Worldwide)

April 26^{th}, Tuesday: May Options Expiration CME

**
**

** **

One

may ask, what does the above imply? The above implies that normal

liquidity will not be present for the last 5 days before expiration.

Sunday Evening US time is usually quite liquid during London hours, but

will not be this week. Monday will also be a liquidity ghost town, as

LME players will be out. It is doubtful that many US futures liquidity

providers will be in the day after Easter either. This is a market ripe

for an event.

Throughout

this week and next, we will attempt to break down the factors

influencing the outcome of this expiration as a proxy for understanding

commodity options risk in general. It will include:

· The players and their biases

· Option Greeks demystified

· How to spot when a market is ripe for “management”, like above.

· Regulatory factors enabling this behavior.

In

any single trade, the option buyer and seller are fundamentally at

odds. Both types of player (referred to as options long and options

short) make their money in opposite ways, and at the expense of the

other. The long players expect to make more money scalping Gamma than

they lose in Theta over the option’s life. The Short players bet that

the Theta they collect will outweigh the market movement and the

negative Gamma they incur, most poetically described as “wishing for

death”.

To understand how and why markets sometimes get

“managed” at expiration it would make sense to first understand the

Option Greeks. This combined with who the players actually are, and

understanding the regulatory inconsistencies will tell the full tale on

why markets are ripe for manipulation near options expiration.

**
**

** **

**Keeping Score**

Managing

Options risk is a complex task. We are going to focus here on only

three of the “Greeks” used to quantify and manage risk, Delta, Gamma,

and Theta. These are the most important ones affecting an option

trader’s behavior as expiration approaches and the market is hovering

near a strike. We’ll attempt to explain them plainly and simply through

examples. For these explanations we must assume that all other Greek

parameters: like volatility, rho, etc remain static to better isolate

the effects of delta, gamma, and theta on risk.

**
**

** **

**Delta **

In physics Delta means rate of change. In calculus Delta is the tangent of the trajectory. But

Delta actually has 3 definitions in the practical trading world. These

definitions largely overlap but are not necessarily the same for the

whole life of the option.

*1. ***Correlation with the underlying**:

a Call has a 20 delta. The model generating that delta assumes the

Call’s value will change by 20% of what the underlying changes. *E.g. Crude Oil goes up by $1.00. The Call will go up by $0.20 assuming other Greeks remain the same. *

*2. ***Hedge Ratio:*** *The long 20 delta call would be directionally neutralized if it had a hedge of short 0.20 futures per long options contract. *E.g.
I am long 100 Crude Oil calls with a 20 delta. I will sell 20 futures
to hedge myself directionally. Therefore I will (theoretically) neither
make nor lose money in either direction due to underlying movement. I am
directionally “flat” *

3. **Probability of Expiring in-the-money**:

according to the model, said 20 delta call has a 20% chance of expiring

in-the-money. e.g. an option with 30 days to expiry at this volatility

has an implied probability of a 20% chance of expiring in-the-money.[1]

** Gamma: **

Gamma is the second derivative of the option. In physics, it is the rate-of-change *of*

the rate-of-change. In calc it is the tangent of the velocity. For our

purposes it is simply how much a delta itself will change (Correlation,

Hedge ratio, or Probability), given a change in the underlying price.

Using

our Crude Oil 20 delta call option again: Crude rallies from $90.00 to

$91.00. In our example, the option has a 20 delta and its

correlation/hedge ratio/probability all point to a change in the

option’s value of $0.20. But that cannot be entirely correct if one

measures the option’s value at the end of the $1.00 move in crude.

Because

the market has moved higher, the option has an increased probability of

going in the money. Therefore its Correlation, Hedge Ratio and

In-The-Money Expiration Probability must increase. In our example, we

use our model to re-calculate the delta of the call and find that its

delta has gone from 20 to 25. This difference of 5 deltas over a $1.00

move is its Gamma.

Therefore

we now have the ability to sell 5 more futures against our 100 calls if

we wish to rebalance our directional risk. We get to “Sell High”. And

if the market drops back down to $90.00, the option’s delta will once

again become 20. We will get to “Buy Low”. Such is the virtue of being

long Gamma. The ability to sell when something goes up, and buy it back

when it comes down. Provided of course your model is right, and as we’ve

said multiple times other Greeks don’t change. Gamma however comes with

a cost called Theta.

**
**

** **

**Theta **

The

rate at which an out-of-the-money option loses its value over time is

Theta. In short, it is the rate at which your long lottery ticket wastes

away. As time goes to zero, your out-of-the-money option’s chances of

expiring in the money go to zero as well. It is

not unlike having tickets to an event that you wish to sell. If interest

is tepid in the event (Jethro Tull : Bore ‘em at the Forum) and you

can’t get face value for them from someone, you are said to be

out-of-the-money. You will lower your price as we get closer to the

event itself in the hopes of unloading them. That is an imperfect

example of Theta.

Using

our 20 delta call again: if it has a Theta of .05. That means it will

lose 5 cents of value per day from the march of time, again assuming all

those other Greeks we are not talking about remain the same. So as a

holder of that Crude Oil call with a 20 delta, you are in a race against

time. If you cannot make more than 5 cents per day from delta

readjustments (aka Gamma) after the underlying moves, you will be a net

loser of money. Put another way, you must “scalp your Gamma” to profit

by 5 cents daily just to break even on your option investment. More than

5 cents and you profit, less than that and you lose.

**
**

** **

**Options Yin and Yang **

Gamma

and Theta are opposite sides of the same coin. These risks and how they

are managed by opposing counterparties, combined with the asymmetric

setup in the system are the key to the reasons for why so many option

expirations get “pinned” at a strike with large open interest. And also

why rarely but more sensationally, markets blow through strikes with big

open interest.

[1] So,

we can say that given no changes in implied volatility or any other

Greek, and assuming that markets are random in their movement 100% of

the time, that information is disseminated in these markets

instantaneously, and finally that liquidity is deep and continuous in

the option itself those 3 definitions above should overlap 100%. ** **

But

we know that none of the above is true, that markets are not efficient

and that the playing field is not level due to economic, regulatory, and

technological differences in participants. This is over and above the

different skill of players involved.

*About
the Author: Vincent Lanci is a 22-year veteran of the commodity option
markets. He started on Wall Street at Lehman Brothers and is a former
floor trader and energy fund manager. He currently manages Echobay
Partners, a private equity firm specializing in commodity and exchange
related investments.*

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