Return To Sender
Vol #155: November 16th, 2023
Auric Goldfinger is the archetypal Bond villain. With his shimmering yellow leisure shirts and chunky gold rings, he infects extravagance into all his devious plans.
At only 42 years old, the Latvian immigrant has become the richest man in London. More or less conveniently though, the entirety of his wealth is kept abroad, tax free, in gold bullion. Our Midas obsessed metallurgist cheats at everything from golf to gambling, and is planning a $15B heist of Fort Knox. For a man who covers his lovers in gold, there’s never enough.
Yet despite assistance from the Mafia and the Purple Gang, Auric can’t stop Bond from getting word out to the Feds and the plot is deflected. Goldfinger however manages to escape with his hostage in an airplane filled with the bullion. After sending Odd Job out a plane window and a final struggle with the boss, James gets the plane turned back around. It then runs out of fuel and after a crash landing, sinks into the ocean, expedited by one of the densest naturally occurring elements.
Physical assets bring with them a lot of problems. $15B worth of gold in 1964 would have weighed something like 25 million pounds at the going price of $35/ounce. That would take days to move, no matter how big a turn out the Cement Mixers or Spangled Mob could manage. (ChatGPT tells me 100 workers with wheelbarrows, moving 200 lbs at a time, would take 200 continuous hours of work to move this haul only 100 yards.)
There’s a reason futures contracts are created. I can fairly easily pick up a significant bit of gold with a few clicks in my brokerage app. Gold is worth a lot more today ($1970/troy ounce), but roughly $50B of notional gold trades on the COMEX every day in just futures.
Gold is valuable because of its use cases in industry, its objective beauty, and perception as a store of value. (2-1 vs. Bitcoin.) While financial contracts only get me exposure to the last part of the equation, every future is underpinned by the physical commodity. If I want the gold to spin into wires and earrings, I can designate a warehouse to accept delivery of 100 ounces for every contract.
Everyone tangentially related to the markets is aware of settlement risks. There’s the mythical intern that accidentally forgot to check a box and had a pile of pork bellies land at their door in Greenwich CT. There’s the very real negative price of oil futures that happened in April 2020 where traders were paying to get barrels off their hands, faced with the prospect of delivery they couldn't take.
For the most part physical settlement is an afterthought best avoided. Even for the producers or consumers who are primary commodity users, the price hedging transactions remain mostly a financial concern. Yet other traders have taken advantage of the delivery process in attempts to manipulate the market.
Appropriately named for our Bond villain, Anthony “Chocfinger” Ward made multiple attempts at cornering the cocoa market. No stranger to this confection - after two decades of trading cocoa and coffee for Phibro, he was named Chairman of the European Cocoa Association - he placed his largest bet ever in 2010.
By taking delivery on 7% of the global supply, some 250k metric tons of beans worth $1B, he attempted to corner the market in advance of holiday demand. With a keen sense of production from his multiple facilities around the world, he managed to become the go to source for any candy makers looking to start ramping up before the October harvest could deliver more beans.
While there was much hubbub around this at the time, just as when he made a similar bet in 2002, Ward was not found guilty of anything other than being a size player. The price of cocoa did rise to a multi decade high on the backs of this move, but the extent to which he profited is unknown. We do however know he has a penchant for rally car races across Kenya and a million dollar wine cellar.
Physical settlement produces quirky opportunities and fun stories in commodities trading, but for anyone trading equity derivatives, it’s mostly a huge pain in the neck. Options have value both intrinsically and as a portfolio component because of their direct relationship with the price of the underlying. But that doesn’t mean they have to turn into a pumpkin at midnight.
The first options strategy that anyone learns about is the covered call. It’s elegant in its simplicity and easy to understand for stockholders. We’ve talked many times before how this is ultimately a volatility trade - how well priced is that upside tail - but the perception of a “win-win” on the upside and a little prem-o to cushion the downside markets itself.
Selling a call option is an unbounded risk, there is no limit to how high a stock can go. (At least you're capped at 0 with a put.) Yet a level 1 options trader can do this for as many contracts as they hold 100 shares of stock. No matter what happens, the broker can take those shares and deliver them at expiration. There’s no risk of default because no matter what the shares are worth, you have 100 to hand over. 1
With a covered call you back it up with shares because they mimic the hockey stick, but with a put to the downside you just need cold hard cash to secure the contracts you write. They know you have the cash to buy the stock for that price, and won’t let you withdraw until the obligation has expired or returned for the market price.
Spread trading allows you to offset a long and a short position to have a defined risk no matter what the outcome. Other options take the place of stock or cash, which means there are wonky things that can happen. A long butterfly position has two short options in the middle, and if these are ITM calls or puts, there is the risk of early exercise. A dividend or interest event easily puts you at risk of getting long or short way more shares than you bargained for with a simple debit trade.
The physical settlement risk in equities is enough of an anachronism to drive me to index options. As I am generally inclined to invest in indices for diversification and fee reasons, that makes index options a natural choice for nipping and tucking holdings. But the major benefit beyond this is that they are cash settled and there’s no physical exchange required.
European settlement is helpful as it obviates the need to worry about getting delivered shares early, but the real beauty of index options is that when expiration happens it’s just an accounting true up, not the movement of any gold bars or paper certificates.
The tidiness of this makes for a more precise experience for end users. If your butterfly is sitting close to the center strike at expiration, with an equity underlying you’re often forced to close early. Depending on which side it lands from the center strike makes a big difference. This means there’s a lot of foregone extrinsic premium, but bid-ask spreads also widen out into the final moments because your counterparty has the opposite but identical concern.
Index settlement means the butterfly is worth what the mark on the underlying settlement price says it will be, and nothing but cash is moved where it belongs. I wonder why about 4x as much trades in SPX notional compared to SPY.
Unfortunately for the prospects of cash settlement in equities, the elegance of the covered call is a mixed blessing. If you only hold 100 shares of a stock in your brokerage account but nothing else, where do the funds come from to cash settle the call you shorted which is now worth more? That’s an even more complicated question for retirement and non margin accounts.
It’s important to keep those accounts engaged with options strategies. While the vast majority of volume is traded in accounts with portfolio margin or haircut treatment, customers of all sizes are the true life blood of markets. Fragmenting volume into cash or physically settled equities would be a net negative - there’s no reason to divide what has become a deep liquid pool of some 30M + contracts per day.
But given options market emperor status for a day, I’d add an extra check box for margin trading accounts. “Return to Sender.” I want all my equity options positions settled at the closing print in cash. Punch everything ITM (the OCC already does this to a penny) and cross any resulting long/short shares on an ATS at the closing price of the stock. Opt out if you need to take delivery for some reason, but I’m happy to pay the postage for a cash settlement.
Notably, this isn’t true for all margin systems. The largest crypto options exchange Deribit margins in the crypto asset, but denominate the strikes in USD. If you have the BTC, December 29th, 40,000 call, that’s currently worth about .05 BTC. BTC is trading at $36,863, so the option is about $1850 in USD. If BTC settles 2023 at $41,850, that option will also be worth $1,850 USD. But in BTC, at $41,850 per USD, that’s only .0442 BTC. Longs lost digital gold.