20 Things to Do Before You Ask for a Price (Part 4)

11 snips

Dec 2, 2024

In this insightful discussion, the speakers delve into the key aspects of effective derivative sales trading. They highlight the importance of understanding volatility and risk assessment to enhance client relationships. The role of the sales trader as a communicator is emphasized, especially in navigating complex option pricing. Additionally, they explore the dynamics of bid/offer in relation to implied volatility, revealing how knowledge can add alpha to the trading process. Overall, it's a deep dive into the nuances of risk transfer in today's electronic markets.

Ask episode

AI Snips

Chapters

Transcript

Episode notes

ADVICE

Calculating Bid-Offer in Volatility Terms

Calculate the bid-offer spread of a trade in volatility terms, especially for longer-dated options.
Appreciate vega risk, as mispricing options with high vega can lead to substantial, long-lasting losses.

INSIGHT

Understanding the Client's Full Picture

Consider the client's overall trading strategy and potential future trades.
Be mindful of situations where a client's subsequent trades could negatively impact your trader's initial position.

ANECDOTE

Capital Structure Arbitrage and Deep Out-of-the-Money Puts

In 2002, the emergence of capital structure arbitrage trades involving selling CDS and buying deep out-of-the-money puts caught equity derivative desks off guard.
This led to significant losses for those who sold these puts without understanding the full extent of the buying interest.

Get the Snipd Podcast app to discover more snips from this episode

Get the app

Welcome back to the last installment of “20 Things to Do Before You Ask for a Price”. This 4-part series has been geared towards illustrating how the equity derivative salestrader can be a meaningful part of getting two institutional counterparties to “yes” with respect to the transfer of option risk. The salestrader, sitting between the trader and the client, can quarterback the process by appreciating the context of the trade and contributing insights on the risk profile of it. Context is about the client, the underlying stock, the trade motivation and the risk environment. The risk profile is about the many nuances of different option trades and what they imply for how the sell-side trader will think about pricing and providing capital.

In today’s highly electronified markets, prices are streamed continuously by tireless bots with neither faces nor names. But risk transfer still occurs the old-fashioned way as well – and these voice trades require superb communication, led by the salestrader. If you are executing upon “20 Things”, you are adding alpha to this process. Below are Things 16-20. I hope this 4-part series has been interesting and you’ve enjoyed the perspective.

16. What is the bid /offer is in vol terms? For example, if an option has 30 cents of vega and the bid / offer is 50 cents, the vol bid/offer is 1.6 vols. Bid / offers on long dated options often seem wide in terms of prices, but are not really in terms of implied volatility. This can be useful in defending your trader’s price.

17. Look at the combo. Check the implied vol on the put vs. the implied vol on the call of corresponding strike. Are they reasonably the same? If not, there could be a borrow issue or a dividend issue. When put vol is much higher than call vol, a borrow issue is often present. In instances where market is forecasting an increase in dividends, it is also the case that the put vol will be higher than the call vol.

18. Understand div risk. On long dated options, dividend risk is a big issue – especially for high delta options where the stock hedge is large. Example: buying the Jan’25 35 puts in VZ carries a great deal of dividend risk – if we buy the puts and buy stock we are effectively buying the dividend stream which, if cut, is painful. Use the Bloomberg function DVD and BDVD.

19. Know put/call parity. C = S + P = PV (K) – PV (Divs) and be prepared to use it to explain pricing to accounts especially on deep in the money or out of the money options.

20. Lastly, have an opinion on every single price you get. You should have a feeling of what you think the price should be before you get a price. Understand that traders are responsible for prices, but that your informed input is very important.