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.
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 21st, Holy Thursday: day before a holiday
April 22nd: Good Friday: CME Closed
April 23rd,Easter Saturday: Markets Closed
April 24th,Easter Sunday: Markets Closed
April 25th, Easter Monday: LME Closed (Largest Physical Bullion Exchange Worldwide)
April 26th, Tuesday: May Options Expiration CME
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.
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.
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
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.
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.
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
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.
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.
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.
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.
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.
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.
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
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
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%.
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.
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