Slip Risk
Vol #162: January 18th, 2024
Here, mornings start with Java Jampit or Tanzanian Peaberry.
I grind the beans, boil the water, and drop it all into a French press. With the coffee still percolating in hand, I open the back door and meander across the yard to my office. At least half of the year it’s still dark, but these zen pre-dawn moments are built for options traders.
It’s not quite like San Francisco where lunch was the best breakfast burrito you’ve ever had, but a fair number of my Chicago mornings were spent in the office watching the sunrise over Lake Michigan. While now practically abandoned, an advantage of working around the old CBOE/CME buildings was that you had wide open views to the south and east.
Fueled by Redding Roasters, I still do my best writing and coding in the morning. And when the rest of the house wakes up, I dutifully bring what’s left of the pot back to the kitchen.
Retracing my steps across the yard, I watch the school buses tumble down the hill that leads to our white clapboard town center.
Since a majority of the country is now covered in snow or freezing weather, the risk in this journey increases. I took a nasty spill last week, but my elbow managed to cushion the coffee pot on the way down. Not quite like catching a baseball with a baby and beer in your hand, but I was pretty proud of myself.
While my arm hurt like hell, and coffee was everywhere, at least I didn’t have to pick up broken glass. Until later that afternoon. The metal frame was slightly dented, which left the glass carafe looser than normal, and it slipped out in the sink. The fall was a flesh wound, not paying attention when doing the dishes is what sent me to Amazon.com.
The risk of walking across a sheet of ice is slipping and falling. That’s bad because either your bones or your beaker will break. But what actually ended up costing me money, was shirking on the details.
Headline risks are scary because they’re big and bold in 24 point font. It’s the exceptions and coincidences that garner extreme levels of attention. When it snows, homeowners buy shovels and ice melt. The Patch sends me 37 e-mails with accumulation updates. When Fed governors talk, traders buy puts.
Over the hill former market makers talk about slip risk, because they’ve been conditioned to pay attention to their jump risk. Also called gap risk, this is a framework for analyzing your PnL outcomes under various circumstances. If stock and vol “jump” or “gap” to these levels, how much money do I make or lose.
This usually takes the form of a matrix, where stock prices are juxtaposed against volatility moves. On an individual portfolio basis this is important to know just how big your risks are so you can make sure you’re appropriately compensated. You can’t have a six figure risk if you haven’t been generating PnL to justify that.
It’s also the framework that clearing brokers and the OCC use for Portfolio Margin calculations. They don’t care about your daily PnL, just what happens if something moves and THEY can’t close your position and have to wear the loss. The CME fences their SPAN margin system with 16 different scenarios - you have to have capital or some multiple of capital to cover all of them.
A core tenant of the options pricing model is the idea of continuous and dynamic hedging. It’s such an important concept that one of the foundational books of options trading by N. Taleb is titled as such. An option’s value is derived by a replication model where stock can be continuously hedged (with no transaction costs of course). If you can’t manage your deltas, you’re not trading volatility, you’re just winging it.
This is why market makers hedge. They buy or sell options for a slight volatility vig, and then do their best to neutralize all the other risks. Hedging astutely and effectively is what generates a billion dollars in revenue for thirteen straight quarters. Pick up enough scraps to pay the transaction costs and bolster your account against the unexpected.
Jumps are scary because they add discontinuity. If the customer sold a call, the dealer is long and will sell stock against it. If stock goes up, the dealer sells more stock because the call is gaining in delta, and the directional risk must be neutralized. They might sell at $10, $11, $12. However if stock gaps from $10 to $15 overnight, the market maker hasn’t been able to sell at those incremental levels and is happy because they accidentally and fortunately rode deltas up.
But dealers both buy and sell options, and gap risk is usually focused on that trade turned upside down. You’re short deltas and haven’t been able to buy them. (The risk of the long option is that it decays theta on you, so being naively long is choosing a slow death over a quick one.) Gaps are a risk of being short options, and they’re a driver of the premium charged upon entering a trade.
The price of liquidity will be driven by the probability of gaps. High volatility is one thing, but gaps are an entirely different matter. If anyone was watching Spirit Airlines this week (SAVE) they saw some incredibly juicy puts trading at 300-500 vol. When the JetBlue merger failed, stock took a 60% dirt nap. Trading this was expensive though not because of the vol, but because of the price you’d have to pay to get that vol.
Are market makers feeling pain on that trade? Eh, some will have won and some will lose. But if the outcome of that trade dictates your year, you’re doing it wrong. A favorable gap gives you a nice production tailwind, and maybe the negative gap clips you back to reality, but the business of outcomes is the wrong game for a dealer to be playing.
All the dimes and quarters those thousands of contracts traded gave up, that’s what pays for the gap risk. Some jumps are winners, and some jumps are losers, but the money that funds your business and pays your shareholders is made and lost on the edge you collected to get there.
Gaps feel like a big deal, because everyone’s first look at options is through the lens of convexity. Where stock goes really matters, because that’s what the PnL charts we all learned from teach us about an option’s terminal value.
Dealers will absolutely complain about a gap. Sarepta Therapeutics brought our best trader literally to his knees. Even a tiny jump in a random name gets every call bought yesterday reported to the suspicious activity forum. It can also be fun, where teammates are on the hook to buy each other golf clubs if someone has a gap winner.
But there are so many more complaints about small stock pickoffs where the auto-hedger whiffed on deltas. Even more about how an order router accidentally hit the AMEX early so everyone pulled their quotes across exchanges. Why did my price improvement logic carp this an extra penny? Remind me of the fee schedule on BOX? (Confusing, because it’s inverted.)
The microstructure is where the hay is made. There’s no pain on slips, gaps, or stock outcomes. If a trader looks at his sheets and sees that under X scenario Y happens, the entire job is finding out a way to be compensated for that or hedge it away. I’m far more disappointed in my dish washing ability than the fact that I fell on some ice.