Fair Market Price

The feedback loop of option pricing

Good Morning!

This is the Jumping Cholla. The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!

Let’s set the tone with the quote of the day:

"We are selling to willing buyers at the current fair market price"

We are selling to willing buyers at the current fair market price

-Jeremy Irons, Margin Call (film)

During the "sell it all" scene in the film Margin Call, Simon Gruber reminds us what dealers do...they buy and sell at the fair market price (± a little taste of 'edge' to wet their beaks, but we'll get into that another day).

Today we are going to learn how these bookmakers make/take so many bets and how it relates to our all-powerful BANG.

BANG for Your Buck:

  • SPX ref = 3849.28

  • BANG (daily) = 53 handles of movement ~1.4%

  • BANG (weekly) = 116 handles of movement ~3.0%

In the coming week, this section will be beefed up with even more relevant and actionable data such as: weekly bang review, overnight expectations, gap probability analysis, and more! Believe it or not, the market just kinda tells you all this stuff, if you know where to look...

Today's Learnding Moment

Who do you buy options from?

Well...since options are bets, you're just trading with a bookie!

Bookie - Ace Rothstein

In the world of "high finance", they like to call themselves a plethora of things: dealers (2), market makers (4), liquidity providers (7), etc. And paraphrasing George Carlin, the more syllables (3), the more bullsh*t the jargon, so let's just stick with bookie (I'll use dealer interchangeably when I'm feeling classy)!

The bookie and the gambler have a symbiotic relationship: the bookie needs customers, and the gambler needs to place bets with someone who can actually payout on a win. The lines gotta be fair too, because if the gambler can't ever win, the symbiosis evaporates and they're all out of business! 

For now, let's ignore how the bookie makes their money and focus on the part that actually gives us actionable market insights...

How can the bookie take so many bets without going out of business?

The simple answer must be, the bet is offset with another bet. Ideally, another gambler comes to the bookie and just bets the other side of line. Whew, that was easy!

But no, most of the time the bookie will need to initiate their own bet (on the same side of the line as the gambler who bet with them) with a different bookie. (yep, this is as safe as it sounds!)

Don't get me wrong, it works, and some may even call this "dynamic hedging".

It just introduces reliance on other market participants, additional liquidity, more counterparty risk, more complex risk model assumptions, etc. all to materialize into the most convoluted game of hot potato ever conceived!

Hot Potato

Thinking of options trading as just a zero-sum game makes sense from the simpler brokerage client viewpoint, but it vastly underestimates the ecosystem required to support these bets.

The insight comes from monitoring the ecosystem that enables these bets!

Let's think about market movement. How does the BANG tell us where the option bookmakers are pricing the potential for underlying movement and what does that have to do with dealer hedging?

Take a peek at the circular reference loop created by the system:

Circular reference loop of option pricing

So, here's the gist, multiple variables create positive and negative feedback loops with each other, and eventually some dealer gives the marketplace a number it perceives as the fair market price. Oh and this is just for a single option; they do this for all options, at all expirations which span years, across all available markets, and on a real-time continuous basis. Everything interrelates, and that, my friends, is where we come in...

The Jumping Cholla monitors changes in dealer hedging, BANG analysis, supply and demand, and more! Then we distill these insights into our newsletter so you don't have to!

Okay, I gotta end it here for today... my brain hurts. And this is just the tip of the iceberg. Soon we'll get to some practical examples to help you digest. 

As always, pursue the process NOT the profits! See you tomorrow!