The movie “The Hummingbird Project” focused on two cousins who attempt to build a fiber-optic cable to create the fastest data link to Wall Street (from Kansas).
DB2
@PickTrader thank you for your clear explanation.
Wendy
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Dear PickTrader,
The thresholds on the link seem to be st dev, which swings very wide of what you are saying.
Where would the triggers be for what you are describing?
This is not a good analogy for options. When person A sells an option to person B for $100, if that option expires worthless, A gained $100 (from B), and B lost $100 (to A). None of that $100 goes to person C who bought an option that didn’t expire and went from $100 to $1000.
In the case of person C, they bought that option from person D, and person D got very unlucky because the call option they sold was on a stock that went up by quite a lot in the interim.
But in either case, and in all cases, the loss/gain between a buyer and a seller of an option are solely between that buyer and that seller. It’s not like horse racing where 100 losers fund the gains of one or two winners.
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The trigger for the trade is when the premium is large/small enough to make the trade profitable. This generally happens on a news event (e.g. tariffs cancelled) and traders rush to buy a large and liquid market proxy, in this case, the S&P futures. Its price rises immediately, faster than each individual stock, and generally keeps rising as more market orders rush in. This triggers the program trading which slows the futures rise and increases the spot index rise. As long as the premium remains high, program trading continues and the market tends to keep rising until it gets to where it wants to be. That’s why traders watch the indicator as a very short term indicator of trading direction.
As to why there would be a standard deviation, they are trying to predict their profitability based the average of a collection of their historical results. (As an aside, I’m sure their slippage costs are far from normally distributed, skewing heavily towards higher costs.) But that’s the formula for one particular program traders.
A standard deviation on the website would come because the website owner has a large database of premiums he’s seen and how much program trading has occurred at that premium. When it’s barely profitable, he would see just a very small indication of program trading when the first guy jumps in. As the premium increases, more and more program traders would come in, causing his program-indicator-happening indicator to jump substantially. He’s trying to describe the distribution of his large dataset with just a couple of numbers, which is where standard deviations come in.
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A good description of the actual mechanics of option trading but does not explain why many options expire worthless which is what I was trying to illustrate.
The Captain
The time span is so short expiration is a nonissue. The futures movement are small.
Dear Picker,
What generally is the duration of a trade?
What is the range of the roi?
I don’t know. I never worked in that part of the business. I was aware of them because they sometimes affected the markets.
This is nonsense.
Let’s assume US listed equity options, which is what is most relevant for this board and thread.
These markets don’t operate the way described above.
First, investor (persons A,B,C etc) trades will be taken by a market maker (on the exchange) that takes the other side of the contract for each trade.
Person A will not trade with B, C will not trade with D, etc, this is fiction, also known as making stuff up.
Second, listed options have centralized clearing.
There is no concept of two investors being linked to each other for account credits/debits related to a specific contract.
Further, if exercised, contracts will be selected at random, having no specific link to the counterparty taking the other side of the opening trade.
This is wrong: “the loss/gain between a buyer and a seller of an option are solely between that buyer and that seller.”
Person A does not gain $100 from B, etc, more fiction.
We’ve gone through this whole conversation before. Obviously we don’t buy options directly from each other, because that would be ridiculously cumbersome to keep track of, and you couldn’t actually have a market that way. But conceptually, it is exactly what happens. I’ll try one more time, but I’ll add the market makers so you can see that it is still indeed true.
Person A puts a sell order for an option at $99.95. Market Maker 1, once the price is reasonable (based on a bunch of things, but mainly bid/ask prices) Market Maker 1 will take the trade, and buy that option from Person A. Meanwhile at roughly the same time, Person B has a buy order for that option at $100 (that is literally the definition of bid/ask prices, there is always a person B because if not, there would be no bid price - that happens sometimes with thinly traded options), and Market Maker 1 who is willing to earn a 5 cent spread on that option trade will sell that option to Person B for $100. Some time passes and that option expires worthless. What is the essence of this trade in the end?
Person A received $99.95 from Market Maker 1.
Market Maker 1 received $100 from Person B.
Person A gained $99.95 (the option premium)
Mark Maker 1 gained $0.05 (the spread)
Person B lost $100 (the option premium)
All the money, every penny of it, that Person A gained, and that Market Maker 1 gained, came from Person B.
Is it true that there are a whole bunch of Person As and Person Bs at any given time? Yes! Of course, that’s the definition of “market”, multiple buyers and multiple sellers, each presenting a price they are willing to buy or sell a specific item. Is it true, that individual buyers and sellers aren’t directly linked to each other for each transaction? Yes, that’s how financial markets generally work for great efficiency. But nevertheless, the people that bought that option at $100 (or whatever price their bid was accepted at the time), when that option expires worthless, ALL THE MONEY, without exception, that was gained by the sellers of that option (and a little by the middlemen, the market makers) came from the buyers of that option.
I don’t see why this is so hard to understand. It is simple arithmetic of a trading market. The same applies to onions*. If 100 onion farmers bring 3 tons of onions to market, and 1000 buyers buy all those onions at various prices, then the total amount of money received by those onion farmers (minus the fees they pay to the owner of the market location), every penny of it, comes from those onion buyers.
Now, you want to bring up all sorts of combinations of trades? Again, yes, that is an entirely different trade. But if you separate out the actual trades, let’s say the buying of a stock, and let’s say the selling of a covered call at roughly the same time, then the gain-loss chart at different prices looks different. Well, of course it looks different, because there are bunch of different trades happening, each with its own characteristic. And we combine them in various ways to achieve the risk-reward scenario that we want. But that still doesn’t obviate the fact that when an option expires worthless, ALL the money gained (on that particular option) came from the buyers of that option.
* Did you know that onions are the rare agricultural commodity that isn’t allowed to have a futures market by law? Very odd historical artifact.
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Such a long reply was not needed to acknowledge
- market makers are the primary liquidity providers and
- listed equity options have centralized clearing
yet you wrote upthread:
(and similar examples in other threads) and you wrote:
But here:
You seem to be making a point about the net total gain/loss of the trades in your example, but that is not my point (my points are the bullets above).
Here’s a third (near) fiction (not literally a fiction, but effectively a fiction).
The implausibility of the perfectly balanced trading book.
Two examples.
and
In these examples the trading book is perfectly balanced so that each and every call and put from an investor (person) for every underlying, strike, expiry and size has an equal and offsetting trade from another investor.
You wrote that B “just happened” to come along at ”roughly the same time” as A to trade the exact same instrument in the exact same quantity.
That might be true in a toy example, but not much at all in the real world.
The market maker’s trading book will not be balanced in that way (and neither will the aggregate options market for any given underlying).
Suppose the vastly more realistic case that, from the first example, C buys a long call with a market maker (versus the ridiculous case of all investor trades perfectly balance each other out).
Assume C holds til expiry (say 1 year), exercises the in the money option for a gain of $1000 (= stock price minus strike at expiry), for a net gain of $900 (= $1000 - $100 premium).
What is the expected return (gain/loss) of the market maker on this single trade with C (which is profitable for C)?
It’s positive. And very different from $900.
What if C’s option expires worthless and C loses the $100 premium?
What then is the market maker’s expected return?
It’s positive and not $100.
Investors A,B,C etc executing trades with market makers is vastly more realistic than these investors executing trades with each other.
But if people want to believe that the option fairy (stealing a line) magically joins them to somehow trade the exact same underlying, calls/puts, strikes, expirys and quantities, at the same times, so that the trading books exactly balance longs versus shorts, and that examples like this improve understanding of how these markets work, then go ahead, believe it.
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I’m replying to Wendy so as not to offend any of the posters in this thread. An excess of words just muddles the waters.
The issue is clearing the market in the most efficient way possible. If there is no lubricant trades can only happen when there are exact matches in the buy and sell books, a penny difference would stop trades. The Market Makers are the lubricant. They make trades when a stubborn market refuses to do so. The exchanges make money when trades happen. It’s in their interest to keep trades flowing.
When discussing the market in the abstract it is perfectly reasonable to ignore the role of the Market Makers, they are just a part of the clockworks. My own mental model of option markets is based on gambling casinos, not gamblers vs. gamblers but gamblers vs. the house. The game is rigged against the gamblers, the odds of every game favor the house. If this is true, how to play the role of the house instead of the role of the gamblers?
KISS!
The Captain
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Dear Picker,
I studied this in the CFA program but did not realize the trading durations would be that short.
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