THE WILLIAM MARGRABE GROUP, INC., CONSULTING, PRESENTS
THE DERIVATIVES 'ZINE^TM     November 2001

Dr. Risk's Trading Post^TM  Last revised: March 02, 2002

New, this month:

• "Ask Dr. Risk!": "A Concrete Answer to a Hard Question about a Cement Company"
• Dr. Risk's "Derivatives Dictionary^TM": flipping, Level I, Level II, Levell III, moon shot, ...
• Dr. Risk's Links 

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On this page:

Ask Dr. Risk!^TM | Derivatives Dictionary^TM | Derivatives Digest^TM | Essays | Links | Pricing Calculators 

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Ask Dr. Risk!

Dr. Risk promises you at least a brief response to your important question, as soon as he has a free moment. A question of sufficiently general interest to make it into the 'Zine, tends to generate a more comprehensive response. All questions and answers become the property of The William Margrabe Group, Inc

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A Concrete Answer to a Hard Question about a Cement Company (7/28/00)

Dear Dr. Risk – What does the EV mean? (Different from EVA, We came across this term in a report by CSFB)  How do you calculate it? – Gaurav

Dear Gaurav – Obviously, EV could have any of thousands of meanings. Which report? What was the context? Without further information, my expected value (okay, maybe just modal value) for random variable EV would be "expected value". – Dr. Risk

Dear Dr. Risk – I'm sorry I was not clear about my question earlier. I came across this term EV in a report by CSFB Hongkong (Equity Research, 26 July 1999) which was about the cement industry in India titled Indian Cement Industry: Swinging into a Deficit. It was used as a parameter for valuing companies. It is not Expected Value. Ratios like
EV/ton (of capacity)
EV/Sales
EV/EBITDA
were used. What do these ratios signify? – Gaurav

Dear Gaurav – In this context, EV is the acronym for enterprise value, which equals the total value of the company’s equity and net debt. All these ratios are tools for looking at the firm’s value, compared to its scale of operations. An equity analyst might try to use them to asses the firm’s relative value, compared to similar firms. For more definitions that involve EV, see http://www.csquest.com/Web_User_Guide/appendix4.htm. – Dr. Risk

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$64 Question (6/28/00)

Dear Dr. Risk – I just went long on qualcomm today and bought a heckuva lot.  The price was 64.  Obviously I think that is a terrific price cause I sure bought a lot.  Now I need some protection.  What is a call option?  I am told july 70 calls are a good form of insurance.  what does this mean?  thankkyou – Van Doren

Dear Van – Not to wallow in self-pity, but a Risk Doctor sees a lot of personal financial tragedy. To make a medical analogy, a lot of patients walk into Dr. Risk's office with self-inflicted injuries and ask for treatment. Your situation is a little like the patient with a case of gonorrhea who walks in and says, "Doc, I think I need some protection." If the patient had come to the doctor in advance, the protection would have cost about 50 cents and come in packets of three or twelve. Now the treatment will require expensive penicillin, with no guarantee of success.

<<What is a call option?>> A call option is an option to buy or "go long". Check out our "Derivatives Dictionary". You'll find the "C"s at http://www.margrabe.com/DictionaryAJ.html#sectC.

<<I am told july 70 calls are a good form of insurance.  what does this mean?  thankkyou >> Assuming your question is serious, it means you're listening to the wrong person, possibly an option salesman! Ideally, insurance protection makes you whole after an insured loss. Of course, life insurance may not exactly make the beneficiaries whole after the insured's death. Some people may never recover from the loss, while others may be better off without the person - even without the insurance!

You said that you were long the stock. Dr. Risk can't think of any way to use a static position in July 70 calls to provide adequate protection against a loss on a $64 stock. The standard protection against that loss would be a static, out-of-the-money put option on all the shares of stock, struck at 60 (say). The put option (also in the dictionary) gives you the right, but not the obligation to sell the stock at the strike price on or before expiration. For every dollar the stock price sank below 60 (say), the put option would provide one dollar more profit. The option gain would offset the stock loss. 

You could use those (short) calls as part of a dynamically changing portfolio that provided protection equivalent to the put. However, Dr. Risk wouldn't recommend it:

(a) That strategy is complicated to explain and you don't sound prepared for it until you do some more reading about options.
(b) That hedge would be what we call an "alligator hedge", because the transaction costs would eat you up. That's why Dr. Risk thought maybe an option salesman might have proposed it to you.
(c) July 70 calls would expire within about a month, and you would lose all the time value within that period. This accentuates point (b).

If you have enough money to buy "a lot" of a $64 stock, then you might consider investing some time reading some books about investing money. Then you won't have so much need for Dr. Risk's ... 

Best wishes – Dr. Risk

Dear Dr. Risk – thankyou very much for your well informed advice. (i didn't understand the thinking at all behind the call option strategy); I thought puts made sense also, but as you can see, I know nothing about options. Because of my heavy investment in qcom, now I must learn. (I do have one of mcmullin's books on options, but I am "sort of" already in Qualcomm pretty deep (ha!), a risky bet no doubt, but by the time I really understand option protection, (and read the book thoroughly) the stock might be a heckuva lot higher than my price of 64. I figured get the stock first at that price. One last question: I have 10K left in cash and you know my purchase price. I would spend it all on some downside option protection. Once we get to early november I think the odds are very good that qcom will go up with the rest of the tech/net sector. Therefore, should I be thinking about October puts on qcom, and if so, how much protection can I buy, and how? What are the costs, prices? I am only worried if the stock goes below 57. I can sweat bullets between my price of 64 and a retracement of 7 down point..........thankyou very very much. – Van Doren

Dear Van – You're welcome.

Dr. Risk can't respond directly to your current message.

1. You seem to be asking for specific investment advice, and we don't do that in this space. We try to use your specific situation as our motivation for presenting relevant, nonspecific information

2. The sort of specific information that you seeks is what a broker or dealer would step on his children to provide. Sounds like you've already figured out what you want to do and just need somebody to tell you how much of it you can do for $10,000.

Your situation suggest that it might make sense to reiterate a general point to our readers. In the options market, for every Rick Lazio who makes 600% on call options on stock in an associate's business, there are more than a few John Q. Publics who lose their entire investments. In the futures market, for every Hillary Clinton who turns a totally inadequate margin deposit of maybe one thousand dollars into $100,000, plus or minus change, there are probably millions of retail speculators who lose money – a little, everything they had, or everything and then some. The equity market is no more of a sure thing.

Best wishes – Dr. Risk

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Spreading the Wealth (5/28/00) 

Dear Dr. Risk – Is there any financial benefit in doing horizontal spreads, i.e., buy Citigroup Sept 65 calls and sell June 65 calls at a debit spread of around 3.  Then around June 18, reverse the above at a credit of 4 (hopefully) – George 

Dear George – Without a doubt there’s significant financial benefit in doing a horizontal spread (which some people call a calendar spread or time spread). Unfortunately for you, over the long haul, the customer typically provides it, and it tends to accrue to the market makers. They’re “the house”, and somebody has to pay to keep it running. In the long run the house receives a competitive return on the resources it employs to perform its function. Nothing amazing about that.

Let’s take a look at some market data. On 5/25/00 at 3:04 EDT, Citigroup common was bid at 60 11/16 and offered at 61 11/16. The market for Citigroup options was

                     bid           ask          spread
Sep 65           3 ¾           4                 ¼ 
June 65        13/16          1              3/16

So the bid-ask spread in each of these options is at least ¼ point. You’re planning on making the round trip, so let’s say that’s going to cost you ½ point, total, plus commissions that we’ll ignore for now. So, you would pay ½ point for the privilege of investing 3 3/16 = 4 – 13/16 in this time spread. That means about 15% of the value of this position goes straight to the market maker. This is for a trade that will last about a month, probably less. If you make a habit of doing this sort of thing, it’s hard to see you doing it at a profit. 

You didn’t explain your motivation, but Dr. Risk guesses that (a) you think and hope that the market for Citigroup wouldn’t go anywhere and/or (b) volatility will increase. Holding volatility constant, if the price didn’t move much, then time decay on the short June call would be greater than the time decay on the long Sep call. Holding the price constant, an increase in volatility will have a larger impact on the option with the farther distant expiration. 

One or both of these things may occur, but Dr. Risk wonders why you want to bet on them. Did you have some sort of inside scoop on where price and/or volatilty are headed? Maybe you just had dinner with Sandy Weill and he said that Citigroup was going to announce in a few days that it had found some glitches in its risk management software, and all its risky positions were really twice as big as they had thought, and not hedged. If so, vol might pop and time time spread might look pretty good. So would a long straddle. Of course, you’d have to worry about the SEC nailing you for insider trading. Maybe you just feel lucky. If that’s the case, why not fly to Atlantic City, take in a show, play a little blackjack? Alternatively, does your state have Powerball? – Dr. Risk

10-4 on your charitable foundation. – Dr. Risk

Dear Dr. Risk – Thanks for giving me such a good education and for your point by point responses to my questions.

With regard to day trading, you mentioned in a previous e-mail, that certain persons did well, SOES Bandits.  They exploited their knowledge of the workings of the system to pick the pockets of the exchange's specialists.  You said that you thought that this loophole had disappeared.  From an academic standpoint (and also a non-academic standpoint)  just what were these workings of the system that were exploited ?  Maybe the loopholes have not completely disappeared.

– George 

Dear George – You’re welcome! Dr. Risk lives to educate others – and himself – about the workings of financial markets. You ask good questions, so it works well. 

The SOES Bandits used the Small Order Execution System to pick the pockets of “specialists” (market makers) on the exchange. In the past the specialists had been able to routinely pick the pockets of investors who placed limit orders. 

First, envision a quiet market, where the market price is bouncing back and forth in a narrow range between the bid and the ask. Limit orders are sitting there, waiting for execution, but the price doesn’t move enough to reach them. Likely, the specialists are providing the liquidity in a narrow range. 

Next, imagine that major news hits the market and it’s clear that the market price will be much higher than it has been. The specialists are able to buy from all those customers who have placed limit orders to sell from the old market price up to where the specialist thinks the new level will be. Then the specialists can start selling from that inventory, making money on every sale. It’s like taking candy from a baby, and it’s one way the specialists made a living for decades. 

Next, come the DOT computerized order placement from the broker’s terminal to the specialist’s terminal for institutional investors. The big dogs, such as Morgan Stanley, were able to place simultaneously large orders for hundreds of names. This is called program trading, done with a computer program, and includes “index arbitrage”, where the trader goes long the stock basket and short the index futures or short the stock and long the futures. It allowed the big dogs to pick off the limit orders before the specialists could. The specialists weren’t happy, and complained, but the big dogs had too much clout.

Next came the Small Order Execution System, which is to NASDAQ what DOT is to the exchanges. SOES allows certain nimble retail traders off the floor (SOES Bandits) to send small orders of 1000 shares or less directly to the specialist for immediate execution. This makes it possible for the SOES Bandits to pick off the limit orders before the specialists could, so the specialists cried bloody murder.

Is money still on the table, waiting for nimble people to grab it? I don’t know. Maybe there’s so much competition that the easy money went away. Anyway, for more details you might look at a promising book that I stumbled across, but have neither bought nor read. In it, Harvey Houtkin, the original SOES Bandit, "reveals his ... techniques"! 

Houtkin, Harvey, and Waldman, David. Secrets of the SOES BANDIT. New York: McGraw-Hill, 1998. The original SOES Bandit "reveals his ... techniques". As usual, take it with a grain of salt. – Dr. Risk

I look forward to hearing what you learn about national and single-state muni bond funds. – Dr. Risk

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Dear Dr. Risk -- I am not knowledgeable enough to answer your question, " Is there  a more powerful level below that of marketmaker ?".  I believe that if you are a client in a day trading office, you can sit in front of a computer with Level II software and trade stocks at one penny per share plus some fixed charges which are unknown to me. 

I read your download and found that not only did I not understand some of the technical answers, I did not understand some of the questions.  Butterflies, strangles, pteridactyls, etc. 

I am going to select about 30 stocks and track horizontal calender spreads,  3-10 points out of the money, buying July and selling June.  Then I will sell (theoretically) the July and buy the June on June 14 or 15 (2-3 days before the June options expire).  On all purchases I will use the ask price and on all sales, I will use the bid price.  Between now and June 14-15, I will monitor the stock prices and reverse out the spreads if there is a chance that I might get called the stock.

I will let you know as soon as I learn the difference between Single State Muni Bond Funds and National Bond Funds. -- George

Dear George -- Thanks for telling Dr. Risk about the stuff that isn’t clear to you. Apparently, Dr. Risk is not as lucid a writer as he thought. 

Butterflies, strangles, and pterodactyls are all “combinations”. Definitions for all those terms appear in the little dictionary on TradingPost page. Try to see how they are all related. Ask what do any two combinations have in common? How do they differ?

Best wishes on your calendar spreads. Dr. Risk has nothing to add to his previous remarks, except that you’ll know how you did in a few weeks, and Dr. Risk is eager to hear. – Dr. Risk

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Dear Dr. Risk -- Last week I sold 7 covered calls of Cintas June 40's. I received $4 per contract ($2800). The price of Cintas is now 43 3/4 and the price of the option is 4 7/8. The expiration date is June 16,2000

Should I take my loss and buy it back at 4 7/8 ? Or should I wait and run the risk that my 700 shares of Cintas gets called
away at 40 ? -- George

Dear George -- Dr. Risk does his best to avoid giving his readers specific advice on trades, preferring to stick to more general comments that fall into the category of “education”. He has nothing to add to his previous remarks at this time. – Dr. Risk

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The Wrong Box? (5/28/00) 

Dear Dr. Risk – Can you please send me examples of Long Box arbitrage, Short Box Arbitrage, Conversion Arbitrage and Reversal Arbitrage?  – Charlie Greene

Dear Charlie – Dr. Risk assumes that you want hypothetical examples, because finding an arb is about as easy to find as a rat with a social conscience, and its shelf life is about the time it takes rats to consummate a physical relationship. 

First, some definitions. A reversal (q.v.) is a cash sale (short the underlying) and a synthetic forward purchase (long call, short put, same expiration and strike). In a reversal arbitrage, you can cover your short sale with the synthetic forward  purchase at the strike, at a guaranteed profit. That involves reinvesting the proceeds of the short sale at a sufficiently high interest rate to cover any dividends and still have more than enough to pay the strike price at the option expiration. For example, suppose the stock pays no dividend. You short the stock at $100 per share, invest the proceeds for a year at an 10% APR, and synthetically buy the stock forward for delivery in one year at $105. Your arbitrage profit would be the present value of $5 per share at expiration, less the $4.50 (say) present cost of entering into the synthetic forward purchase. 

A conversion (q.v.) is a cash purchase of the underlying and a synthetic sale (short call, long put, same expiration and strike). It's the other side of the reversal. In a conversion arbitrage, you buy stock, sell it synthetically forward at the strike, and lock in a profit. For example, if the stock pays no dividend, you might buy it for $100, borrow the money to do it at a 10% APR, and synthetically sell the stock forward for delivery in one year at $115. Your arbitrage profit would be the present value of $5 per share at expiration, less the $4.50 (say) present cost of entering into the synthetic forward sale.  

A  box (q.v.) is a reversal at one strike price and a conversion at another, all the options with the same expiration date. The value of the box at the expiration date is the conversion's strike price minus the reversal's strike price. The cost of the box is the cost of entering into the synthetic forward purchase and sale. The usual definition of a box has the conversion's strike price higher than the reversal's, hence the box pays off a positive cash flow at expiration. This is a long box. For example, if you could do the illustrative reversal and conversion, above, you would lock in a profit that equaled the present value of $10, less the $9.00 (say) present cost of entering into the synthetic forward purchase and sale. At the 10% APR, the present value of $10 is $9.09..., and the value of the arb is $0.0909... A short box consists of taking the other side of the long box transaction. Modifying the immediately preceding example, if the cost of entering into the synthetic forward purchase and sale were each -$4.60, then the short box would give an arbitrage profit. 

If you're off the trading floor, the probability that you will do one of these arbitrage trades is infinitesimal. By the time you would get wind of such an opportunity, a floor trader would have scooped it up. – Dr. Risk

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The most important thing about trading is ... (4/28/00)

Dear Dr. Risk – What was the impact of all those people copying the LTCM trading strategies? – Jerry Lyons

Dear Jerry – An old joke about comedy goes something like this: 
     Q: Ask me what's the most important element of comedy. 
     A: Okay. What's the most important element of ... ?
     Q: Timing!

One might equally well say that the most important thing about trading is timing, and LTCM's rise and fall illustrates this point. Most of LTCM's positions were spread trades, long one thing, short a related thing. Incidentally, most of the spreads were essentially based on credit quality. Suppose that LTCM thinks that spread = yield #1 – yield #2 is too wide and will narrow. Then LTCM thinks bond price #1 – price #2 is too narrow or negative and will increase. So LTCM buys #1 and shorts #2, which might push price #1 up a bit and price #2 down. After that, if someone piggybacks on LTCM’s trade, they might push price #1 up some more and price #2 down some more. This results in yield #1 falling and yield #2 rising, which narrows the spread, tending to fulfill the LTCM prophesy in the short run. Ordinarily, this didn't make much difference, because we're talking about LONG Term Capital Management. They weren't day traders. 

However, suppose that clairvoyant traders find out that LTCM has suffered reverses and will have to scale back some of its positions, or is even “dead” and will have to liquidate. In anticipation of LTCM's trading, they can do the trades that LTCM will have to do, perhaps pushing prices the wrong way for LTCM. When LTCM liquidates, selling #1 and buying #2, this may further depress price #1 and boost price #2, hurting LTCM’s P&L. The clairvoyant traders can then close out their positions at a profit for themselves. – Dr. Risk

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Jonathan Livingston: "Seagull?"  (11/28/99)

Dear Dr. Risk – What is Seagull Strategy? And how is it different from Butterfly and Condors?  – Jonathan Livingston

Dear Jonathan – Dr. Risk hadn't heard previously of the Seagull Strategy, so he asked Sheldon Natenberg, author of  Option Volatility & Pricing. Chicago (Irwin Professional, 1994), who trades in Chicago and teaches trading around the world. Shelly answered, as follows: 

"I have never heard the term 'seagull', but there is a lot of non-standard terminology in our business. I suspect that the spread is one of what are called 'wingspreads', the most common of which is the butterfly (buy one option at each of the outside exercise prices, sell two options at the inside exercise price). If we separate the inside exercise price into two adjacent exercise prices, the spread become a condor. If we further separate the exercise prices, the spread becomes what some traders call an 'albatross', which is what the inquiry probably referred to. 

"The following examples might help: 

"I even know one trader who refers to a 'pterodactyl' as being a wingspread where the inside options are three exercise prices apart.

"In a wingspread all the options expire at the same time and are the same type (either all calls or all puts). It is also possible to do some of the options synthetically, which leads to what are referred to as iron wingspreads (iron butterflies, iron condors, etc.) 

"In a long wingspread a trader will initially pay some amount, and hope that the underlying market is either at or between the inside exercise price(s) (the body of the spread) at expiration so that the value of the spread increases to its maximum. In a short wingspread a trader will initially receive some amount, and hope that the underlying market is outside the extreme exercise prices (the wings of the spread) at expiration so that the value of the spread collapses to zero. In the above examples each spread at expiration has a minimum value of zero and a maximum value of 5.00.

"This terminology probably sounds rather strange to an outsider, so I sympathize with your reader. I hope this helps. – Shelly

"P.S. I meant using put-call parity to do some of the spreads synthetically. For example, a long iron butterfly is a long straddle together with a short strangle: 
long one 80 call / long one 80 put and short one 75 put / short one 85 call
But this is identical to a short butterfly since we can express the 80 put as
long one 80 put = long one 80 call / short one underlying contract
and we can express the 75 put as
short one 75 put = short one 75 call / long one underlying contract
The long and short underlying positions cancel out, leaving a short butterfly."

Shelly, thanks for your explanation. – Dr. Risk

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IPO Fever and Rookie Mistakes (11/28/99)

Dear Dr. Risk –  I've never invested before, but I have a great opportunity coming up with an IPO.  My question is the following; Lets say that I buy 500 shares at $17.00 ($8500.00 ).

When I sell, the stock is at $70.00. Does this mean that I've made $53.00 profit on each stock= $26,000.00.  Perhaps, if I sell, the total investment  would be  500x70= 35,000.00.  Is the stock going to sell for $70.00? Does this mean that I've made a 411% profit? 

You may find this questions totally ridiculous, but I just want you to understand that I'm not familiar with any investment strategies.  I will greatly appreciate if you can assist with this request. – RB

Dear RB – While I can't comment on your specific situation, my impression is that making one's first investment in an IPO is similar to making one's baseball debut in a game in the American League. No doubt, it will be exciting!

Your financial arithmetic questions sound hypothetical, since one would ordinarily not know the future price of any stock. Continuing the baseball metaphor, your questions about profit and percent profit are analogous to questions about the basics of hitting and fielding, which are a bit surprising, coming from one who's about to play professional ball. Analogously, Dr. Risk is more of a football coach (financial engineering and risk management) than a baseball coach (investments). However, the simple arithmetic questions are well within Dr. Risk's range – he’s sort of a utility infielder. The answers are:

• Purchasing 500 shares at $17.00 implies an investment of $8500.

• Selling at $70.00 does not affect the investment, but leads to a return of $35,000.

• The profit would be $26,500 = 500 * $53.00 = 500 * ($70.00 - $17.00) = $35,000 - $8500.

• As a percentage of investment, the profit would be 311.7647% = 100 * $26,500 / $8500.

Dr. Risk can't help wondering if your next question will be, "Who's on first?" If so, please direct that question to Abbott and Costello, not Dr. Risk. Best of luck! – Dr. Risk

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Fun with Options (9/28/99)

Dear Dr. Risk – I am a reasonably intelligent person (I guess, by most people's standards) with a graduate degree and nearly twenty years of management experience. I have been fascinated with a recent taste of options (and their related elements) that I have read through various information and broker sources.

The issue – I don't know squat about derivatives and never studied or learned anything about them all through my education and work experience. Yet, I feel I want to learn because it appears to me one could make money trading options and have some fun in the process, as well. 

Hence, my good erudite scholar and practitioner, is this something worth my time to get involved in, or is it just a trail of broken glass that will inevitably leave me with scratches and bruises? With the proper study, can one learn enough fundamentals and be relatively prepared to venture into the investment waters, with conservative money management, and have a good chance at being successful?

I have recently read about "delta neutral trading" which seems to offer some fascinating possibilities. Can you tell me what this is all about and explain it or refer me to some good books or periodicals where I can do some "beginning" reading? Any help or guidance that you could extend to this neophyte would be greatly appreciated. Naivete aside, I really desire an educated opinion on this search for a potentially useful avocation. Thank you very much. – Spike

Dear Spike – The fact that you feel fascinated with about options after reading sales literature is not a huge surprise. It wouldn't be good sales literature if you didn't. 

Dr. Risk has spent about 28 years studying options and futures, about ten years teaching them at university, about seven years supporting option sales and trading and – rarely – have traded them for my personal account. (The 28 years contain the ten and seven, which overlap.) This has not made Dr. Risk optimistic about the prospects of a retail customer making money in the options market, just as he is not optimistic about the short-term financial prospects of a gambler  in Las Vegas. The bid-ask spreads are relatively large and the short lives of options force turnover once every nine months or so. (Except for LEAPS.) So retail option trading is a lot like feeding the slot machines. 

Your career as an option trader would likely have some ups and downs. If you own calls during a bull market, you will look and feel like a genius, and you could accumulate substantial wealth from very little. However, the downside might be like a trail of broken glass, and the damage to your financial health could go beyond scratches and bruises – you might cut your jugular vein and find yourself in a life-threatening situation. If you buy an option and it expires, worthless, the rate of return on the option is negative one hundred percent. That could happen for an extended period of time, and it has happened to many people. 

Shelly Natenberg's book on option trading contains a wealth of information for you, if you decide to trade options. He's an experienced options trader and master teacher of option trading, who can make the subject accessible to beginners. See the related icon, blurb, and link, elsewhere on this page. 

Delta neutral trading for a retail customer is a particularly good way to lose all your money, with no chance of winning in the long run, because transaction costs will eat your capital. The idea is to figure out an option's replicating portfolio of underlying asset and riskless debt – i.e., the portfolio of the underlying asset and riskless debt that behaves like the option. (Theory tells us there is such a portfolio.) Delta neutral trading consists of buying (selling) an option and selling (buying) the replicating portfolio. After you've done this, if the underlying price moves, then the option value changes. If you make money on your option, then you tend to lose the same amount on the replicating portfolio. To the first approximation, and on average, you'll neither make nor lose money. If you adjust your position, you are dynamically hedging. Nassim Taleb's book, "Dynamic Hedging," explains all about this. You can find a related icon and link from this page to that book's page on Amazon.com. 

There is a second order effect in delta trading, due to the option value function's "gamma" or "convexity" – its curvature. Thus, if the price movements – up or down – tend to be big, then a long (short) option position, delta hedged, will tend to make (lose) money. If the price movements are small, then a long (short) option position, delta hedged, will tend to lose (make) money. However, there is no way for the retail investor to turn this into a money machine. 

If you've got enough money to think about dabbling in option trading, then you've got enough money to manage well. I would suggest pursuing the study of risk management. It's something you ought to know before you get into option trading, or else you need someone else to hand you the rules. 

If you're lucky, after a year or two of studying risk management, your urge to trade options in the retail market will go away. – Dr. Risk

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Statistical Arbitrage (5/28/99)

Dear Dr. Risk – Where can I find more about the different methods of statistical arbitrage? – Dilip

Dear Dilip – The literature on trading strategies is vast, and much of this literature concerns statistical arbitrage, although not always referring to it by that name. You can find books in your bookstore, or on Amazon.com. I'll survey the topic, to give you a better idea what to look for.

Classic arbitrage consists of buying something cheap in one market and immediately selling it for more in market – without tying up capital or taking risk. The classic example of arbitrage is the currency dealer on the phone with two customers – a buyer and a seller. The dealer has learned that they are eager to trade, and at what price. So – within a few seconds, at most – he buys from the seller, then sells to the buyer at a higher price.

Clearly, this sort of trade is extremely attractive. Equally clearly, the existence of arbitrage is difficult to justify in any theory of economic equilibrium – or common sense. We could argue that the opportunities aren't truly arbitrage opportunities. A customer could change his mind in the middle of the arb, or stock index basket and index futures prices might move differently between the time of placing and filling the orders. If such opportunities occured predictably, then traders would show up to exploit them, which would destroy the opportunities. For example, if you and the world know in January that credit premiums will be too large during the following summer, then as soon as the excess premiums start to show up, you and the world will buy credit risky debt and sell credit riskless debt, which until the prices fall back into line. This will permanently keep credit premiums in line with reality.

Statistical arbitrage is nothing more than a spread trade that has favorable odds of becoming profitable. Other names for such trades are

• long-short strategies
• pairs trading, one long, one short
• market neutral strategies, which should make money whether the market rises or falls
• convergence trading, indicating that a price relationship that is out of line should come back in line

Often, the calculation of favorable odds comes from extensive analysis of historical data, but sometimes traders go on simple theory and casual empiricism.

My experience is mainly in the area of options, where dynamic hedging is the main form of statistical arbitrage. One family of spread trades involves being long (short) a complex, derivative instrument and short (long) the replicating portfolio of underlying instruments. A parade of traders – with David Askin in the middle – have done this with mortgages and mortgage-backed securities vs. Treasurys and Treasury options. Convertible bonds vs. shares and ordinary corporate bonds provide another example. Perhaps the most common example is equity options vs. the underlying shares and money market instruments, or currency options versus the two underlying currencies.

Other types of statistical arbitrage include

• index arbitrage, e.g., shorting the "rich" S&P 500 index futures contract and promptly buying the "cheap", corresponding basket of shares.
• event arbitrage (formerly known as "risk arbitrage", until that name lost its lustre) in the market for shares of companies involved in takeovers
• volatility arbitrage involving a forward start option and options with different expiration dates
• basis trading, involving cash and futures, or two futures contracts
• zero duration trades involving a portfolio of fixed income securities
• zero beta equity trades
• classic long-short hedge funds
• credit spreads.

Other types of arbitrage, with statistical elements, include

• tax arbitrage of the differences in tax treatment of economically identical portfolios
• regulatory arbitrage to pick the most lenient of regulators for a portfolio of risks

Wanting to know more about statistical arbitrage is like wanting to know more about the ways to prevent cancer. The types of cancer are different, and you can avoid them by different means, such as avoiding lung cancer by not smoking, skin cancer by staying inside during the summer midday, liver cancer by avoiding hepatitis, etc. Similarly, different types of statistical arbitrage call for different methods. While I don't have ready sources for most of these types of statistical arbitrage, the most readily available, authoritative resource for various option spread trades is Natenberg's book. For dynamic hedging, I'd say that Taleb's book offers a great deal.

Natenberg, Sheldon. Option Volatility & Pricing. Chicago: Irwin Professional, 1994. "Option trading strategies from an experienced trader's perspective. Natenberg discusses extensively a variety of spread trades." – Dr. Risk

Taleb, Nassim. Dynamic Hedging; Managing Vanilla and Exotic Options. New York: Wiley, 1997. "Bridges the gap between what the best traders know and what the best scholars can prove." – Dr. Risk

Once you understand a few types of statistical arbitrage, I think you have a better idea of all the rest. – Dr. Risk

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No, Virginia, there is no Santa Claus (5/28/99)

Dear Dr. Risk – Can you answer the following?

1) Does the 10 year note move at 2/3 the speed of a 30 year bond?
2) If so, can you play this relationship creatively? So that even if I lose money, it is not very often?
3) How do you create a spread between these two using futures or options.

Here is how the sure thing trade is supposed to set up:
Step 1: Sell an in the money 10 year straddle (put and call)
Step 2: Buy 1 out of the money 30 year Call 1 strike above and Buy 1 out of the money 30 year put 1 strike below (buy the T bond strangle)

The author of this trade "advice" says this is creative because it is not what most people would do – do the strangle and straddle on the same instrument. Rather the relationship between the ten and thirty year is a known relationship.

The authors experience was stated as follows:

For a two month period he never worried – he took no money into his account when the transactions were executed but took money in over the life of the trade. The author then said that this is what many of the large bond arbitrage firms do....or at least what they did now that we see the fate of Long Term Capital?

The trades should be initiated when you don't have to pay anything to put them on, and one would not want a net credit either. Does this happen frequently? Is there actually execution risk of buying the one trade while waiting for the other to be executed at a net credit. The author, to his credit seems to want to close this trade out every time the account is at a net credit of $500. Sounds like free money just for putting trades on.

As for risk profile, the commentary was a follows:

There is limited risk because you sell options in the middle, which are the slowest moving options (the straddle) and buying options on the outside which are the fasted moving options.....so if bonds move 50 points in one month, you cannot lose money because you are long the fast moving ones and short the slower ones.

Thanks for any insight – Virginia Madison

P.S. When you have more time can you elaborate on delta neutral trades?

Dear Virginia – Let me start out by answering your three questions:

1. Empirically, ordinarily, the 10 year note moves faster or slower than 2/3 the speed of a 30 year bond. If you wanted to assume that the forward curve moves with parallel shifts, then you could use a standared duration model to theorize about the relative speeds. Assuming a flat yield curve, then a parallel shift in the yield curve would produce bond price changes that were proportional to duration. Then, if the duration of the 10-year bond were 2/3 the duration of the 30-year bond, the price of the 10-year bond would move 2/3 as fast as the price of the 30-year bond.
2. If the market is efficient, then you can’t make money off the relationship between the relative speeds of the 10-year and 30-year, with any consistency.
3. If you want to assume that the 10-year or the 30-year is rich or cheap, then I suppose you might use duration to create a market-neutral spread.

Now, let’s look at the "sure thing trade". If the underlying were the same for all legs of the trade – "what most people would do" – you would have what I call an "underwater butterfly", a portfolio that is equivalent to being short a T-bill and long a butterfly spread on the underlying. Your maximum payoff would be zero, when the payoff on the short straddle was zero, i.e., where the spot price at expiration equaled the strike price on the short straddle.

With a single underlying, this would be a credit trade from the gitgo. Otherwise, how does one take "no money into his account then the transactions were executed" on a strategy that has a totally non positive payoff? It seems to me that you take in the money, up front. You repay it at the end. The question is, how much do you get back from the butterfly?

When you allow the underlying bonds for the straddle and the strangle to differ, you have what I call an "underwater latex butterfly" – as opposed to an "iron butterfly", things are elastic.

With two underlyings you would do this trade at closer to zero initial net cash outflow. The price volatility on the 30-year bond exceeds that of the 10-year note. Hence, the cost of the long strangle could approximate that of the short straddle.

The essence of this trade is a race for the sidelines, where the slow runner has the head start. The trade makes money if the 30-year bond moves far enough, faster than the 10-year does. The 10-year has a head start, because of the short straddle, which means that either the short call or the short put is always in the money – except on a set of measure zero, where the underlying equals the common strike price. However, the 30-year would ordinarily move faster than the ten-year, because of its greater duration. Of course, the 30-year starts out behind, because both legs of the strangle are out of the money.

 As for the comment, "you cannot lose money", of course, you can lose money. You lose money where the 30-year doesn’t move fast enough to catch up with the 10-year. While it may be unlikely, the 30-year might stay dead still, while the 10-year moves. Maybe you would have a rotation of the forward curve around the 10-year point, not affecting the price of the 30-year bond – a long shot, to be sure. If the near end rose, the 10-year would tank, and the strategy would lose money.

 Clearly, in equilibrium, the market takes into account all possible moves and leaves no free money on the table. At least, that’s my assumption.

That’s enough for now. Delta neutral trades, later, maybe. – Dr. Risk

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Derivatives Dictionary^TM  Terms and definitions relating to trading are below. The main Derivatives Dictionary^TM is here. 

(q.v. = "which see" in Latin, so look for the definition of the preceding word or phrase.)

albatross 

Definition: A combination (q.v.) that's like a condor (q.v.), except that the two short calls (or puts) are at two different strike prices, two intervals apart (K-DK and K+DK), between the strikes of the two long calls (or puts) struck at K-2DK and K+2DK.  
Application: It pays off most when the price remains between K-DK and K+DK. 

box, box arbitrage

Definition: A synthetic forward purchase or sale (q.v.) at a low price and synthetic forward sale at a higher price, both purchase and sale at the same forward date. A synthetic forward purchase (sale) consists of buying (selling) a call and selling (buying) a put with the same underlying, expiration, and strike price. Thus, the box is equivalent to a long or short zero coupon bond for the difference in sale and purchase prices. A box consists of a conversion (q.v.) at one strike price and a reversal (q.v.) at another. 
Application: It's a way to use European options to borrow or lend, although probably a last resort for a desperate trader.
Caveat: While the box eliminates some risks, pin risk remains, and if the options are American the risk of early exercise remains. 

 butterfly spread

Definition: A combination (q.v.) that consists of a long call (or put) at K-DK, two short calls (or puts) at K, and a long call (or put) at K+DK, where DK is an interval in strike prices, e.g., $5. All calls have the same underlying and expiration. 
Application: It pays off most when the price doesn't change move from K. It can be most attractive when the market is too "bullish on  volatility" and you're bearish. 

combination, combination option, combo

Definition: A portfolio of one or more calls and one or more puts, sold as a unit. 
Examples: box, butterfly spread, condor, strip, strap, straddle, strangle, butterfly spread, etc., all of which see. 

conversion

Definition: Purchase of the underlying asset (or going long the underlying futures contract) and a synthetic sale (q.v.). If the underlying paid no dividend, interest, etc., the conversion would be equivalent to lending the purchase price and getting back (principal plus interest) the synthetic sale price. 

 condor 

Definition: A combination (q.v.) that's like a butterfly spread (q.v.), except that the two short calls  (or puts) are at two different strike prices (K-DK and K), between the strikes of the two long calls (or puts) struck at K-2DK and K+DK.  
Application: It pays off most when the price remains between K-DK and K.

8/28/00 Darrell Zimmerman Rule

Definition: A rule of the Chicago futures exchanges that allows the clearing firms to keep the profits on any positions that exceed what their margin supports. Named after the man who created havoc in the CBOT bond pit in 1994 by buying huge amounts of option bond options on margin that consisted of a worthless $50,000 check.
Comment: If it had been in effect when Hillary Clinton made her $100,000, Refco would have been entitled to keep all her profits. Of course, that would have defeated Refco's purpose in letting her trade. 
Source: Ted C. Fishman, "...Almost," Worth, 1/94,  2000http://www.worth.com/articles/Z9401F04.html. 

electronic communications network (ECN) 

Definition: An electronic network that brings traders together and enables them to trade. 

Examples: Island ECN and MarketXT are two ECNs. 

Application: ECNs make it possible to use or sidestep exchanges, depending on whether it provides better execution. For example, an ECN can run 24/7, even if all the markets are closed.    

flipping

Definition: Selling out your IPO position without waiting until the underwriter is safe. 
Application: For example, if Underwriter offers 1,000,000 of ABC's shares at $10 in the morning, the issue does a moon shot (q.v.), and you sell out on at $25 in the afternoon, that's flipping. 

Green Shoe option

Definition: An underwriter's right to issue more than the stated number of shares of an issue. Named after the Green Shoe Company, which was the first issuer to grant an underwriter such an option. 
Application: For example, if Underwriter offers 1,000,000 of ABC's shares at $10 and investors oversubscribe the issue, Underwriter can require ABC to issue another 100,000 shares at $10. 
Sources: IFCI, http://risk.ifci.ch/00011628.htm. 

Greenspeak

Definition: The words of Alan Greenspan, chairman of the Federal Reserve Board. "They spend all day thinking up questions I can't answer, and I spend all day thinking up answers they can't question."

 jelly roll

Definition: A synthetic sale of the underlying with delivery at an early date and synthetic purchase of the underlying with delivery at a later date, both sale and purchase at the same price. 
Application: The buyer of a jelly roll gets to use the money from the sale, until he needs it for the later purchase. He has to pay the dividends on the short sale.

Level I, Level II, Level III

Definition: Three types of price quotes that NASDAQ provides. Level I provides the "inside quote", the highest bid and its size, and the lowest ask and its size; exchange fee $1 per month. Level II provides all bids and asks, their sizes, and the party making the bid or ask; exchange fee $50 per month. Level III provides the same as Level II, plus ability to post and change bids and offers, and some statistics; only for registered broker-dealers.
Source: Gibbons Burke, "Level II Quotes: Decoding Supply And Demand," Active Trader, June 2000.

millennium spike

Definition: A sharp increase in the interest rate for days around January 1, 2000, due to concerns about the "Millennium Bug". While it would show up in the daily forward rate(s) for one or more of those days, "Six-month interbank interest rates rose sharply at the start of July, while three-month rates spiked in October. ... [O]ne-month Euribor rates also spiked by 43 basis points at end-November. ... The interest rate spike has been much more marked for unsecured loans than it has for those secured by collateral such as government bonds." (George Graham, Banking Editor, "BANKING: 'Millennium spike' hits rates," http://www.ft.com/nbearchive/email-bfq31246a.htm, 12/29/99.) 

moon shot

Definition: An IPO that jumps 100% in price on the first day of trading.
Source: Jeff Ponczak, "IP OPenings?", Active Trader, June 2000.

8/28/00 O'Hare spread

Definition: An insanely large position in a futures market, plus a cab ride to the airport. At the end of the day, either you've made a lot of money and you hop a plane to Hawaii, or you've lost much more than you have and you hop a plane to someplace out of reach of U.S. justice.
Source: Ted C. Fishman, "...Almost," Worth, 1/94,  2000http://www.worth.com/articles/Z9401F04.html. 

pterodactyl 

Definition: A combination (q.v.) that's like an albatross (q.v.), except that the two short calls (or puts) are at two different strike prices, three intervals apart (K-DK and K+2DK), between the strikes of the two long calls (or puts) struck at K-2DK and K+3DK.  
Application: It pays off most when the price remains between K-DK and K+2DK.

reversal, reverse conversion

Definition: Sale of the underlying asset (or going short the underlying futures contract) and a synthetic purchase (q.v.). If the underlying paid no dividend, interest, etc., the reversal would be equivalent to borrowing the purchase price and repaying (principal plus interest) the synthetic purchase price. 

 straddle

Definition: A combination  (q.v.) that consists of a put and a call, both long and with the same strike price. 
Application: It pays off most when the price moves up or down the most. 

 strangle

Definition: A combination  (q.v.) that consists of a put and a call, both long, both out of the money. 
Application: It pays off most when the price moves up or down the most. 

St. Valentine's Day Massacre

Definition: What happened to J.P. Morgan on 2/14/00 when it underwrote a $500 million convertible bond issue for LSI Logic Corp. and investors bought only $100 million. "J.P. Morgan is stuck with as much as $400 million of LSI's bonds on its books, and the firm is unable to sell them, due to a regulatory technicality, until March 31." (Gregory Zuckerman, "Stalled Convertible: J.P. Morgan Is Left Holding $400 Million of LSI Bond Issue," WSJ, 3/2/00.)

 strap

Definition: A combination  (q.v.) that consists of two calls and a put, all long. 
Application: It pays off most when the price moves up (best) or down. 

 strip

Definition: A combination  (q.v.) that consists of two puts and a call, all long. 
Application: It pays off most when the price moves up or down (best). 

 synthetic purchase (sale) 

Definition: A combination (q.v.) that consists of a long (short) European call and a short (long) European put -- both with the same underlying, strike, and expiration -- and is equivalent to a forward purchase (sale) of the underlying with delivery at the option expiration. 
Application: It leads to a transaction at the strike price on the expiration date, regardless of the spot price then. 

syzygy theory

Definition: A theory of investment that attaches special significance to an alignment of the planets (syzygy). Typically, such theories see syzygy as a bad thing. 
Application: The 5/5/00 alignment of Mercury, Venus, Mars, Jupiter, Saturn and the moon was the tightest since 1962. Author Richard Noone's tome, 5/5/2000: Ice, The Ultimate Disaster, predicts that the alignment will lead to disaster on earth. (AP, 5/5/00)   

three-way

Definition: A combination (q.v.) that's like a conversion (q.v.) or reversal (q.v.), except that a deep-in-the-money option replaces the cash position. For example, instead of a conversion -- short a call, long a put, long the underlying -- a deep-in-the-money call replaces the long position in the underlying. Instead of a reversal -- long a call, short a put, short the underlying -- a deep-in-the-money put replaces the short position.
Application: The three-way allows the arbitrageur to eliminate settlement risk, complicating dividends, etc. 
(Sheldon Natenberg, Option Volatility & Pricing, Chicago, Irwin, 1994.)   

wash-sale

Definition: A sale that the trader follows with a purchase of the same thing within 30 days. The IRS considers such a sale an abusive way of reducing taxes. 

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Derivatives Digest^TM

8/28/00 "Europe's Police Are Out of Luck on Insider Cases." Wall Street Journal (2000 August 17) By Anita Raghavan, Silvia Ascarelli, and David Woodruff.

French investigators started looking about 1988 into suspected insider trading in shares of Société Generale SA. They're still looking. Even if they prove every suspicion, the elapsed time means that the maximum penalty would be light fines, with no jail time, probably. 

Justice delayed is justice denied. Of course, a rush to judgment is unfair. What does that tell us about using criminal law to make the world safe for investors: Don't try to use a meat cleaver to do brain surgery. 

"In the past five years, prosecutors in the big stock markets of Britain, Germany, France, Italy and Switzerland have won a total of just 19 criminal convictions for insider trading. The tally in federal court in Manhattan alone? Forty-six." 

Henny: How's your country's enforcement of securities laws? 
Shecky: Compared to what?

"'There is no enforcement' in Europe, says Ignacio Pena, a finance professor at University Carlos III in Madrid."

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Essays 

Morgan Stanley's Cacacophony (11/12/99)

Morgan Stanley's not the only financial brokerage firm to want to do that. What they're doing is analogous to a family of mutual funds that has a fund for every industry, style, etc. This is part of the motivation behind the coming bank-insurance-brokerage industry. 

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Links Links related to trading are below. Links related to other financial topics are here.

Analysis

• Quicken.com. Free tools for screening investments in and out. 
• Nova. "Trillion Dollar Bet" -- companion website. Nova #2704, about LTCM.
• Nova. "Trillion Dollar Bet" -- transcript. Nova #2704, about LTCM.
• Morningstar.com. Tools for screening investments in and out: $9.95 per month. 
• Zacks Investment Research. Research Wizard.
• J.P. Morgan and Carson Group ADR Research. 

Data

• BigCharts.com. Chart your market data.  
• Federal Reserve Board. Bond prices.
• GovBot. Great web site for finding government reports.
• Hoovers.com. Company profiles.
• Quote.com. Chart your market data.  
• Securities & Exchange Commission. Company data and investment basics.  
• Stockpoint.com. Chart your market data.  

• www.ProphetFinance.com. "Live, Streaming Charts."

News

• 8/28/00 CBS Market Watch. "THE STORY BEHIND THE NUMBERS". 

Investment Advice

• ArmchairMillionaire.