Price Set is Price Paid
Vol #163: January 25th, 2024
New listings are the intersection of uncertainty and opportunity.
While the SPX and NDX consistently grab all the headlines and volume (nearly a third of OCC contracts go to these product complexes), they only trade a tenth of a vol click wide and have deep chasms of size backing up both the bid and offer.
If you’re trying to flex muscles in these markets, you’re one David against a dozen Goliaths. Information is measured in the trillions of dollars, and no participant alone sets the price. The weighing machine of market efficiency brings prices closely in line with reality.
This is great for anyone coming to the options markets for risk transferal and portfolio construction. The slim margins of dealers deliver execution quality to customers, and liquidity providers do their best to make it up on volume. Massive flows that are constantly pushing, pulling, and tugging on implied values set the market clearing price with a high degree of certainty.
Capital flows to where it is treated kindly. Save the rug pulls and gapping price action for the degens, most of the world’s hard earned savings wants to be coddled. Or at least put in a place where it can pay someone 100 bps to explain why they underperformed the index.
Where there is uncertainty, there is less money. Reflexively, and by definition. Lack of confidence in price begets wider markets, which draw less volume, and further reduce confidence in price.
At the height of the liquidity scale, the confidence in price means that trading is extremely precise. Volatility models require dozens of calibrations and polynomial coefficients to describe the precise shape. Minor kinks in a perfect spline must be modeled to not only capture predictable shifts in risk profiles as stocks move, but also recognize orderflow driven values and exogenous variables. Neither Black nor Scholes is aware of the discontinuity that could arise at a specific strike level because of some corporate action.
When a new stock gets listed options, it is the most verdant of fields. Particularly if the equity itself has only traded for a few days prior. This period has been reduced from 5 days to only 2 days as of September of last year. There are some other basic requirements like the stock must trade over $2 (if you can’t list strikes any smaller than $0.50, what’s the point), and there must be a certain number of non-insider shareholders.
While no volume and wide markets pose a threat to all market participants, and tight spreads and vigorous activity bring their own competitive pressures, there is a beautiful ephemeral moment when nothing becomes something, and the magic of blooming liquidity happens in real time.
New stocks to list were something our specialist posts actively sought. Chasing the golden snitch to find a name that for a few weeks became hot, could make your month or even year. Besides just the obvious frenemies in the pit next to you, competitive dynamics amongst exchanges also shortened this timeline. The AMEX might be the first to list a new pharmaceutical thanks to your suggestion, but quickly NASDAQ and CBOE sprinkled it around to their various medallions. Fragmented orderflow, shattered dreams.
There were other dynamics at work unfortunately. Suggesting a name to get listed didn’t guarantee that you got to be the DPM or specialist. The exchanges also wanted firms that could bring in orderflow, and they had to play politics. Continuing to get the nod here required regular coffee dates to remind decision makers of your qualitative value.
New issues are the closest options trading looks to venture capital. Most are duds, but every once in a while there’s something spectacular. The hard part is not picking which ones to include in your portfolio, that dimension isn’t particularly constrained, but rather picking the right price to open it at.
For all the hours that market makers spend trading, there is very little time spent setting the price. Liquidity providers don’t determine the value of an option, orderflow does. But when there is no implied volatility to read, market to join, or even historical price action to review, someone has to set the first price.
When Uber IPOs a month after Lyft, you can look at the implied vol of other rideshare companies to get an idea of what to expect. Comps only get you so far, but with a big name that’s all but guaranteed to bring blockbuster volume, you set your size to the minimum for the open, and quickly take some ten lot licks before repricing with the market.
A Canadian uranium miner is different. Their CEO probably called down to the post because he’s so excited to make it to the big leagues. The only customer interested in the name is a hedge fund with a deep analyst bench. Set your inputs wrong, and you’re wearing the other side of this trade until expiration.
Bitcoin ETFs are a curious case here in two dimensions. While their inflows have smashed every record imaginable, they do not yet have listed options because of some technicalities about the composition of the ETPs which require a special exemption.
Further, when they do actually get listed, there is probably not all that much uncertainty. We have the BITO futures based ETF that has traded for over two years, and even long before that offshore exchanges have been pricing BTC derivatives with roughly 2 million USD (50 BTC) on either side of a 1 point wide market. The call skew, term structure, and even heteroskedasticity has been well modeled. Back to the edge trenches.
It’s not just new listings that present this pricing problem, new expirations like LEAPs have their own headache. Being so far in the future, minor tweaks to dividends or implied forward rates send butterflies down the probability tree. Putting volatility just a click too high means lifting every offer on a $5 or $10 wide market.
Unless they’re pontificating at happy hour, market makers hate setting a price for anything. Sure there are good and bad levels at extremes, but the price is what the market says. The price of liquidity is what matters, not the price of the option or the underlying.
Price discovery can be a lucrative process in the early stages. On the buy side, you can benefit from significant differences as valuations meander towards their platonic truth. I promise you that 27 year old chess whiz with a penchant for risk has no idea what the science behind the FDA trial is. But they are damn good at providing a two sided market for anyone who wants to bet on the magnitude and timing of the outcome.
Prices are set by buyers and sellers. If the market is at all time highs, and the wings have been bid up, it’s not because the dealers need to hedge their vega or are buying cheap teenies. As the flywheel of orderflow and risk transfer picks up, the competitive one upsmanship brings size and squeezes edge. Greeks swing back and forth as edge gobbling machines fire up their engines and swarm the product.
The most common way that dealers determine their pricing is through joining and fitting. They have a curve of what they think everything is worth, and this updates based on how market prices are moving. And regardless of what they think it's worth in their model or cockles, the vast majority of their orders are contingent on where everyone else’s orders are.
Lit markets are both an advertisement and reference point. It tells customers where they can get reasonably filled, and it also serves as a mutually agreed upon reference point of where the industry is collectively valuing a given OPRA symbol. Brokers measure execution quality and market makers determine their individual confidences based on the NBBO.
Setting a new price is scary because it removes the comfortable blanket of liquidity that through volume and transactions warms into tight markets with high confidence in values. Creating implied volatility or rates as an ex machina value is an exercise in being naked and alone.
It’s a loss leader and a sacrifice to the gods of orderflow. The thousands of companies that trade less than 100 contracts a day still have a dozen eyeballs on them because of potential energy. There is a horde of buy side salivating for a catalyst to fire up their terminals for bouts of speculation or sage risk management.
When you have to set the price, you’re likely to pay for it. But if you’re lucky, it does enough marketing such that you can get paid to shepherd the issue all the way to a penny wide.