Tr Tr Tr Tricky
Vol #172: March 28th, 2024
It’s tricky. Tricky Tricky Tricky.
To rock a rhyme that’s right on time. To pick a queen in three card monty. To price an option with an -150% forward rate.
Whether you’re Run DMC or Sheldon Natenberg, haters are coming for your crown. Rhymes are for the nursery. Selling calls is a loophole to get short. Amateurs love to put on a beat, dial up a vol surface, and explain why the pros really aren’t that special.
A gotcha trade happens because it looks like free money. Using options to avoid paying to borrow the stock is a clever newsletter pitch - or bit of engagement farming - but you don’t avoid anything that’s already priced in.
It takes a lot of Texas hedges to understand the ways in which options bend. The pain of short gamma or choking on theta can only be experienced first hand. Forget about the plumbing risks of stock borrows and triple digit negative rates.
Options often look like one thing, but are actually pricing something completely different. It’s at times like these that a simple trade looks obvious, but ends up backfiring. While I still think covered calls are the best way for retail traders to capture volatility risk premium, on the internet they’re most loudly described as free cash. Especially when they’re “mis-priced.”
Trading SPX, AAPL, or even the wild and crazy TSLA, the arithmetic mostly makes sense. MSFT closed yesterday at $421.43. At a 25% implied vol, the 475 strike call expiring in 50 days is worth about $2. A roughly 10% chance of landing in the money. Finger in the wind, check.
Sell the call, buy the stock, and move on. Returns will mostly be equity like, with a dash of padding for the downside, and you’re giving away the upside on a rally over 13%. But even this vanilla trade has something going on under the surface.
Your payout also includes a dividend. May 16th is the day before expiration and also the record date for $0.75 in cash to be delivered to each shareholder. But especially if I’m getting a dividend, why does that leave the 425 strike closer to 50 delta than the 420 strike?
The answer mostly lies in the 74bps of interest that also adjust the forward value of the stock. Options settle based on the stock price at expiration, and in this case the best prediction we have as of right now is that MSFT will be lower by the amount of the dividend and higher by the risk free rate of interest. Throw a probability distribution on top (implied vol) and you have an options pricing model.
The expected interest and dividend yield are baked into the price. The puts know that the stock price is going to be a little lower because cash is coming out of the company. Just like the calls know that the future value of an asset must include an interest rate.
Under normal circumstances with positive interest rates you get paid to short a stock. Assuming there’s plenty of shares to borrow, being short earns you interest on the cash you received from selling the stock. If that stock is hard to borrow, you pay for that privilege of being short. More if there’s less.
The rate that you pay to borrow the stock, then gets priced into the options, because, arbitrage. Mechanically it’s enforced by a put seller or call buyer who has to hedge and needs to price their borrow costs in. Theoretically it’s simply that there’s no free lunch.
Highly negative rate stocks are typically associated with higher implied volatility. A 250% implied volatility obfuscates a lot of things. Options prices just look like big numbers, and don’t jibe with our casual understanding of greeks. One month straddles are roughly half the stock price. Would you expect anything less from ticker DJT?
When Trump Media finally made it through the SPAC-tacle course, it traded 6x higher than when DWAC first listed with the intention of taking Truth Social’s owner public. Forget about who’s at the helm, a run up like that brings all the shorts out to play.
But where to get the stock? Trump himself owns 78 of the 135 million shares available, and he is subject to a 6 month lock up. Barron’s estimates that roughly 10% of the free float has been borrowed.
If you don’t have a direct line to a clearing house, you can guesstimate what the borrow rate is just by looking at the options chain. The forward value of the stock is the strike price where the call and put have equal value. A continental surface divide, where a raindrop of brownian motion is as likely to go to the Atlantic or Pacific.
In the MSFT example, that’s where we see the 425 strike having more equal call/put pricing than the 420, despite stock currently trading at $421. For the same expiration in DJT, that’s somewhere between the 50 and 52.5 strike.
Markets are $5 wide here, so it’s not a precise calculation, but we know that both of those strikes are a good clip below the current share price of $66.22. The options are telling us that in just 50 days, the best guess we have for the forward price of the stock is 20-25% below the current value. And with $1M in revenue per quarter, it’s not because of a $15 dividend.
Put/call parity is the pricing law that holds the left hand side of the chain in line with the right hand side. The whole surface moves up there is demand for volatility exposure. Buyers of vega raise all offers. But directional flow that is biased because of a stock borrow exposure will need to move puts up and calls down. Lower rates, or higher dividends.
The trade that sells (buys) a call and buys (sells) a put is called a combo. You’re synthetically getting short (long) stock at that strike price. The price of that combo compared to the current stock price reflects the cost of carry. You can lock this forward price and rate in by doing a zero cost collar with a combo vs. stock.
Referring back to our simple example, the MSFT combo at 425 (buying put) will cost you about $0.90, meaning you’re selling stock synthetically on May 17th for $424.10. Adding 50 days of 5.5% interest and subtracting the dividend, gets you within a few pennies of that combo market. Extra credit if you consider the dividend timing and interest on that as well as the options premium.
Options don’t just price volatility. They price rates, dividends, and will throw kinks in the curve for events and debentures. If you’re coming to the options market to skirt another exposure, I promise you 45 million contracts traded yesterday to drive that pricing in line.