The Blast Off Window
Vol# 149: October 5th, 2023
My taste in hip hop is very mid. True to the bell curve analogy, the range of listening is probably less than the average standard deviation, and also centered fairly close to the mean.
With all but a few exceptions, it also stopped maturing about 10 years ago, so I’m frozen in time, rapidly developing boomeritis. All of this explains (but doesn’t justify) why I was listening to the flabby midsection of Jay-Z and Kanye’s 2011 collaboration “Watch the Throne.”
There’s a song called “Blast Off” where Brooklyn meets Chicago meets Beyonce. It’s fine. What caught my ear though was the sample of an actual rocket ship lift off that they play. As they go through the countdown from 10 to 0, an interesting thing happens before the end.
The announcer sounds like Walter Cronkite’s brother, and as he hits 0, there’s a distinct pause. It’s a few seconds before “blast off”. When playing rocket ships, there’s never a pause. You might not even count the zero, it’s just go.
To fill that pregnant pause - this anecdote has an aside. Objectively, David Bowie’s “Space Oddity” is a far better song and also has a countdown with a beat drop before blast off. But that’s not what got me thinking about why the stars look very different today.
For this thread to be intellectually honest, I need to expose my basic bro taste and not sheen it over with Ziggy’s stardust. You, loyal reader, would have never known. Writing is the nonlinear unraveling of brain knots - editing is the product. But writing about trading options, I felt the need to move in the direction of clock time, no take backs or white out.
As readers we enjoy a well crafted story that has the benefit of hindsight to foreshadow, weave, and contextualize (or not, Michael Lewis)1. Just don’t look at a trading backtest like a script, or other ex post demonstrations of a signal’s effectiveness. Always ask for the trade tickets. Reality has a lot of slips and gaps. $8B of customer money kind of gaps.
Thinking about the pause led me down a controlled rabbit hole of YouTube rocket ship launches. I’m not the first one. Some narrators say lift-off, others say blast-off, others let the plume of red do the talking.
But for anyone watching an actual rocket ship leave this earth for orbit, you realize everything that matters takes place in that pause. Systems are engaged, and the countdown marks them off. Completing that checklist only fires up the engines, it takes another few seconds before the monumental energy required to produce actual lift-off is summoned.
I can only assume that NASA engineers sweat every millisecond across that gap, while the broad public ignores and cheers right over it. Insiders of course have a much different perspective on systems, and minding the details is what matters most.
Stock settlement is one of those quirks in the trading world. When you click buy on your terminal, assuming you get filled, the position updates immediately. For most intents and purposes, you own the $AAPL stock. When the IRS asks what price you paid, and starts the clock on capital gains, it’s today’s dollars and cents.
But when you ACTUALLY own the stock, is not for two more trading days. If you buy stock at the open on a Thursday, it doesn’t actually make it through the DTCC plumbing until the open on Monday. Over 1% of a year. That change is as recent as 2017. We’re moving into the future early next year with t+1.
The place that this matters is for dividends and interest. Ostensibly minute, these odds and ends of the pricing model matter a great deal to insiders. If there are fractions of pennies to be shaved with the timing of stock ownership, there are dollars that can be made by timing dividend payments.
State Street is the manager of the largest ETF - SPY. Besides collecting a small (but far from the smallest) fee for managing the appropriate portions of the 500 stocks in S&P’s benchmark index, they make money by holding your money.
All throughout the quarter companies pay dividends to their shareholders. The ETF manager tallies these receipts and allocates them out to shareholders once a quarter for “simplicity’s” sake. A few weeks ago they declared the most recent allocation - $1.58317 per share.
To be entitled to that payment, you had to own the stock on the record day. To be an owner of record for the stock on September 18th you had to buy it (or punch your calls) on September 15th. Don’t hold your breath though - that payment doesn’t come until Halloween. Dragging out that payable date for 925 million shares at a 5% interest rate is worth almost $8.5M per quarter. Someone’s long rho.
Absent that kind of market capture, even lowly floor creatures can skim some insider interest cream. Not knowing anything privileged, just how the system works and letting your opponent hit the ball into the net. Every professional options trader I know has a at least one position on in their personal account that came from “f*** it, let it ride”, so you can forgive retail traders for ignoring the minutiae of early exercise.
Investing is a game of inches, but most buy side use cases for options are about direction. It could be long or short vol, overlaid deltas, or just yolo moon shots. The money gained, lost, or saved comes from some explicit exposure.
Dealers make some of their money from charging a fee for inventory management (the bid ask spread). There’s also good money to be made from minding your p’s and q’s in the middle of massive transactions where others are sloppily focused on a bigger picture.
A day or two of early exercise difference means little to one and a world to the other. The overarching decision logic on when to punch has to do with whether an option is worth more dead or alive. “Dead” in this case, means exercised into the underlying shares.
On the call side you exercise your rights to own the shares to get a dividend. On the put side you would exercise to sell stock, and thus reduce your cost of capital owning shares or earn a rebate from short stock. (Sold stock is cash, which earns interest until you use it to buy the shares back.)
When an option is deep enough in the money that the dividend or interest amount is more than the extrinsic value of that option - i.e. certain money is worth more than uncertain potential - it’s beneficial to exercise.
While brokers are getting better about helping option holders exercise when optimal, there’s always some misses. There are also reasonable differences in market participants' costs of capital that change the timing. To capture these misses, market makers run an MEV-like train through the window between zero and blast-off.
Assignments are definitely processed by the OCC randomly. They’re allegedly processed randomly by clearing brokers. Trading firms have fist fights over which account it lands in. If a call or put is not exercised, the short option holders benefit by either the dividend amount or the incremental daily interest.
Who that benefit goes to is random, unless you stack the deck. Like buying all the lottery tickets, but with only transaction costs as your outlay, market makers can open/close contracts that have arbitrage-like risk profiles and dramatically increase their odds of skating away with those “free” nickels.
Make sure you check the “bot-today” box on your exercise sheet, but opening 10,000 contracts on a line with only 1,000 open interest before a dividend, means you’ll benefit from over 90% of the misses. And like an under the table envelope, certain exchanges will cap the fees on these, making it incrementally more lucrative.
If not done properly, this can have explosive consequences. Punching one leg and not the other or failing the punch, from the trader to the clerk, through the clearing firm and down to the final man or machine at the OCC, there’s career ending risk at each junction. The steps are simple, but they must be executed correctly.
Today, the window has all but closed. It’s a combination of firms shying away because from the operational or compliance risk, and the inefficiencies of a market getting stamped out with technology and education.
While anecdotal, the blast off window has also narrowed. My mental regression says that older launches had a longer delay, while more recent ones either say it immediately or drop it all together. Enjoy.
At the risk of this becoming inceptions of sidebars, I’ll footnote the comments I can’t refrain from making on the SBF book. First off, Molly White is a fantastic crpyto journalist and well worth a follow, and her book review is very good. Whether Michael Lewis is a journalist - eh. Like many of my cohort, Liar's Poker was the first finance book I read that got me hooked on the business. I even supported him through the somewhat shoddy retelling of Flash Boys, because despite the technical flaws and plot twisting there was a lot broken with institutional equities trading post Reg-NMS. IEX might not be the haloed answer, but the special order type bandits were definitely taking money out of my pocket.
I think Matt Levine (of course) has the best take on Going Infinite. His point is that you don’t go to Michael Lewis for a critical finger wagging of what imploded with FTX, you come for the character and drama. I’m going to enjoy the book with a nice bowl of popcorn, but it’s yet another reminder to diligence your sources.