On the tombstone of a disturbing number of previously successful careers could be inscribed the epitaph “Why did you want to sell options?” It’s the question above all to which, during my career, I never really found a rational answer. Yes, armed with your Black/Scholes model, you can calculate the ‘value’ of an option, and then make a judgement as to whether the premium generated provides sufficient protection against underlying market moves to make the trade viable. Well, of course, it does tell you that, because that’s what the model is structured around. But the more I think of it - as one interested in mathematics, but by no means a mathematician - the more difficult I find it to see a logical base for the model. Yes, it’s a pretty equation, and Fischer Black and Myron Scholes managed to convince the world that it was the true faith, the Holy Grail of option pricing. Mmm. I think more and more that it works because traders use it; not traders use it because it is intrinsically correct. While the parameters it sets remain where they are supposed to, all is well; when they don’t, though, carnage usually ensues (hello LTCM, how are you, boys?). I don’t have a better solution, by the way, but the more I think about it, the flakier the whole thing seems. Anyway, just something for proper mathematicians to ponder.
One example comes to mind from a long, long time ago. One of my colleagues sold a lot of physical gold and silver to XYZ Ltd. They were a very large manufacturer of electrical and electronic switchgear and stuff like that. Come and see them, he said to me; they also consume a lot of copper and nickel, so we should be able to help them there as well. They were only a short stroll from our office, so I went along and met the charming person in charge of metal purchasing. Yes, they’d love to do copper and nickel business with us; they much preferred our prestigious name to many of our competitors. Why had it taken us so long to bring base metals to them?
What they wanted was simple. They bought physical copper on normal monthly average producer terms. But they wanted to protect themselves in the case of a rising market, so their policy was to buy call options as a hedge against that producer pricing. Fair enough, one may say. But, of course, they didn’t like the way that would cost premium money. Well, OK, I don’t like paying the premium for my car or house insurance, but I do it. Our friends, though, knew they could avoid the ugly necessity to pay us money for this trade by the simple expedient of selling put options in order to balance the premium cost at zero. Could I, they asked, go away and structure a deal like that for them? Could I? Oh, yes, indeed, the consumer min/max was something we loved, not least because industrial demand was weak across Europe and prices were broadly in a declining trend.
They put the trade on - possibly for twelve months, I don’t remember that - and all went well, for a bit. So they came back, doubled the quantity, stretched the time period and seemed very content.
But then, as it seemed almost inevitably, the put option strike price began to act like a magnet, drawing the market down towards it. I can’t remember what the copper price was at the time, but let’s say it was $3000mt. So the mantra then was, well, we don’t mind buying copper at $2800, because we use it all the time. Mmm, but that’s not really quite what you meant, is it? What you really meant was we don’t mind buying copper $200 below the currently prevailing market price. In truth, when the market gets to $2750, you’re not so sanguine about $2800, not least because upstairs is a boardroom full of directors who pose the difficult question: “Why are we paying more than our producer contract price for our copper?”
So the next stage is the request to restructure the hedge. Well, that’s manna from heaven for the trader; restructuring means buying back the offending options, and then selling some more, lower strike ones, to finance the cost. But nothing is free, so the new volume has to be substantially larger, to equalise the premia at zero. It all gets very messy then, and very difficult to control. This is when heads may start to roll.
In this case, that didn’t happen. In the end, they took the loss, and re-thought their hedge policy.They were a huge conglomerate, the sort where even the strictest credit committee doesn’t blink at the numbers, and they could swallow it, so they came out chastened, but whole. Others, selling options, have been a lot less comfortable. The reason this particular example sticks in my mind is twofold. First, there was no other trading, so it was really easy to see the picture developing; and secondly, they were genuinely such nice people - a positive pleasure to trade with.
I know I’ve laboured the example, but I really do question the sense in selling options like this. It’s not just a question of underlying price moves, but the uncontrollable nature of the inter-action of the parameters that make up the pricing model. I have absolutely no alternative to offer, but the problems caused would suggest perhaps a more rigorous questioning. Otherwise, we’re going to continue seeing that epitaph on career gravestones.
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