Spread 'em Tight

Vol #114: January 27th, 2023

Options attract a lot of different types of personalities.

The original options trader was a Greek philosopher.  Based on his study of the heavenly bodies and a good old fashioned hunch, Thales of Miletus predicted there would be a bumper crop in olives the following year. Scooping up all the upside calls he could get on olive press bookings, he profited handsomely from this speculation.

Thales’ estimations of volatility and theta decay were rough, but because he was so directionally correct, it didn’t matter. Fast forward a millennium and head a few thousand kilometers north, and the Amsterdam opsie dealers didn’t know much more about the greeks. They flipped these contracts back and forth as a means of leverage on their newly minted limited liability companies. Mostly they wilted faster than tulips.

These frock coated punters were the original AMC apes and Wall Street Bettors. The idea that you can buy something for a nickel and see it rocket with convexity is tantalizing. Whether it’s astronomy, fundamental analysis, or just gut feel, pure speculation drives a lot of volume.  If you keep your bets reasonable, it can also be a lot of fun. 

The speculators are an important part of the market ecosystem. They are going to be relatively price insensitive and their orderflow is random. Who cares if you pay an extra nickel or dime when stock is mooning tomorrow! This keeps the dealers and theoreticians involved and keen to spot mispricings.

As options have become a subject of intense academic and practical research, the theoreticians have emerged. These are the traders that look at complex implied volatility surfaces to arbitrage synthetic relationships. Keeping your time spreads in line is a 101 level check, while the PhD’s are focused on relative price of variance across a complex of products. 

A call isn’t worth $1.25, it’s a specific bet on a given future interest rate, realized volatility, and potential dividend cut. Third order greek exposures like vanna and charm are forked through an arboretum of trinomial trees to tap an ounce of insight about the future market direction. 

A good market maker must sit somewhere in between these two extremes. When trading for edge and managing inventory, the price you pay matters. Really, in any trade, the price you pay is the most significant determinant of your future profitability. Ask anyone who went all in on tech last year. 

But it’s more than just understanding the slope of the skew or the depth of a time spread. It takes a speculator at heart to have the chutzpah to size up. When the gamma squeeze party comes to upside calls near you, it’s going to take more than a seven factor spline to make you sell something 200% out of the money and expiring tomorrow. 

There are hundreds of other shades of personalities, so don’t feel pigeon-holed. Every trader is a unique $SNOW. 

What matters is where and how they all come together. If you don’t like the market, make a better one. Should my offer insult you, it means your bid is too weak. Liquidity is what happens when all these personalities come together to price probabilities. 

Every trader cares about the width of the market. Regulators do too, as the tickrementation debate recently sparked in equities has shown. 

The Mariana Trench of liquidity is SPY. This year it has traded at least 70% more volume than the next highest issue - every single day. Not only that, of the at-the-money options expiring in less than 30 days, more than half are two cents or tighter.

Less than a penny of edge on either side isn’t a lot of room for a market maker to make mistakes, or market takers to complain about price. That two cents is even more impressive given that the price of a share is again north of $400. 

We know that the implied volatility of an option is the single largest driver of valuation. Those early Greek and Dutch gamblers knew this instinctively - puts on the South Sea Company traded at a different price than Wooden Shoe Holding Co. The non linearity of theta decay is difficult for our lizard brains, but most swashbucklers have an instinctive feel for how much something could move. 

The pricing equation also works in reverse. The price you trade at, implies a certain expected volatility level. With ATM volatility in SPY trading around 17%, I have a thirty day call worth $8.70. Knowing how competitive the product is, selling this at $8.75 seems like a nice big nickel of edge. 

That nickel of edge only gives me an extra tenth of a percent (.001) of implied volatility cushion. I sold 17.1% vol. That’s assuming that you can get your hedge at exactly $400. If stock ticks up, and you only get your hedge at $400.02 - whiffing on a measly .02, you’ve really only sold something like 17.07% vol.

If that sounds like splitting a very fine hair, it is. A vol of 17.1% means SPY is expected to move around about a little over 1% a day, or $4.27. A 17% vol means expecting daily moves of $4.25. 

You have to be making a LOT of well diversified bets, all with a little bit of edge to be trafficking in margins that thin. But it’s great for the punter just looking to go long the market. 

Besides, it’s not just volatility that can move. If Jerome Powell gets a look at the froth still spewing from TikTok real estate gurus, we’re due for another 100bps of hikes. That surprise announcement would probably tank the market, but if it didn’t, your call is worth a whopping 17 cents more than the initial rate pricing, with vol and stock the same. 

With all these potential dimensions for movement, it feels crazy to quote anything less than a dollar wide. 

If every option price represents an implied vol (and rate and dividend) price, then the bid-ask spread can be translated into something like 16.9% vol bid at 17.1% vol offered. This is interesting because it is fungible across issues and prices. You can compare a penny wide market in AAPL to a penny wide market in SPY or AMC. 

Markets are tighter in volatility terms for the same dollar width in higher priced stocks than lower priced stocks. The dollar denominated spread on a 0.2% wide vol market in a $400 name is about 9.5 cents, but only 1.2 cents wide in a $50 name. 

Somewhat counter-intuitively, this does not scale with volatility levels. If SPY was a 50 vol product instead, a 0.2% wide market would still have 9.5 cents between the bid and ask. What does tend to happen, is higher vol products also have a higher vol of vol - the implied vol moves around a lot more . This naturally leads to dealers demanding more edge and posting wider markets in both dollar and vol terms. A market is a confidence interval after all, and greased pigs are hard to wrassle. 

The punter just looks at this and says every penny is a dollar. She’s right - if she buys that call for $8.74 instead of $8.75 it’s an extra dollar in her pocket for every contract, plain and simple. At the end of the OCC’s day, all of those ticks add up to not some abstract surface, but real capital that moves between margin accounts and clearing houses. 

How you think about these market widths is going to depend on your objectives. Dealers managing an inventory of thousands of positions will care about the exact volatility level that trades and how that changes their risk profile. Punters focus on the dollar price, because paying a nickel not a dime means twice as much firepower. 

If you’re somewhere in the middle, and use options as a scalpel for defining and managing portfolio objectives, you want to have a little bit of both. Price matters, so using tools like dollar cost averaging and position rolling helps smooth out some variance and makes your position feel less like a wager. Even if it still matches your objectives, it’s a tough beat when you buy a put spread to sleep easy, only to see the market rally up a wall of worry.

Vol prices matter too, but not to answer whether SPY should move $4.25 or $4.27 per day. If your strategy is to sell a 5% out-of-the-money call every three months (like a certain $20B fund does…) you’re going to get wildly different results. Three months ago when SPY vol was at 25%, you’d have collected about $13.50. Today with vol at 17%, it’s closer to $7.50. 

So whether you define your strategy by delta, dollars, or percentages, all these little ticks matter. With so many ways to frame the markets and think about how to trade them, it leads to a tightly packed room. That’s great for everyone.