Paper Is Always Right

Good Morning!

This is the Jumping Cholla (CHOY-uh). 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!

And even if you don't trade, learning how to think like a trader builds a robust framework for problem solving, taking risks, managing a plan, and just living life.

Quote of the day:

"I just placed a $25 million bet that the market drops by at least 2% by next Friday"

Wait, what trade did Mr. Eye Candy make?

Hot Carl just bought 24,000 Feb 17th 4050 Puts. He paid ~$20.50 for each put. And since this was in the ES (options on the e-mini S&P 500 futures) it cost him 24000 x $20.50 x $50 (notional multiplier) = $24.6m in premium. Equivalent to getting short ~$5 billion in S&P 500 underlying (4050 x $50 × 24,000).

For this to pay out, the market needs to sell off before next Friday. In the simplest analysis, if the market closes below 4029.50 on Friday, February 17th, this trade is a winner. (4050 strike minus 20.50 premium)

Also, remember our post on picking the correct tool for the job… why didn’t he use SPX options? At the very least, his commission would have been half since SPX is double the size, notionally.

The answer is futures delivery. ES options gets you the futures contract, whereas SPX options just settle up with cash deposited to your account.

So, if he’s correct, he will be short 24,000 March ES futures contracts from the price of 4050. Those don’t expire for another month. If he wants the exposure for longer, then this is a good way to ensure he “gets his fill.” If he has a high conviction to the downside, and maybe even thinks the market could “gap” lower, this is the correct tool for the prediction.

So, is he right on his prediction?

Paper is always right! (for you non-finance bros, paper = customer orders) Well, they are right for themselves, and what they want to do…

Market makers / dealers / bookies live by the adage “paper is always right” because paper is the customer. They are the lifeblood of trading. It’s like saying the customer is always right. The store always wants to sell something, and the dealers always want to take the opposite of a customer’s bet.

Do large orders know where the market is going?

Maybe, lol. But even if they did, their management is surely different that yours, they are better capitalized, they might be truly hedging and not betting, etc.

Markets are a meritocracy. The winner gets the spoils. The winner can be “a guy who fell off the back of a turnip truck.” (In one of the first criminal spoofing cases after Dodd-Frank, a defendant said something along the lines of “your honor, we aren’t trading against a bunch of guys that fell off the back of a turnip truck, we outsmarted some of the “smartest people in the world”…yeah, that didn’t work, and believe it or not, straight to jail!) Consensus doesn’t determine the winner, and big bets don’t either.

The only reliable metric is monitoring the ecosystem that can support taking these bets! This is why we focus on open interest, dealer hedging, event volatility implications to hedging, etc.

BANG for Your Buck:

Large Option Positioning

• 4200 strike creates large positive gamma for dealers and will act as resistance above and a magnet below.

• Staying above the 4100 strike is critical support and perpetuates the bullish lean.

• A breach of 4100 will likely test the option support at the 4000 level.

• 3900 strike creates large negative gamma for dealers, which will exacerbate movement near there. In general, a break under 4000 gets the dealers to start hedging with the direction of the market and a pop in volatility.

• "Downside protection" i.e. puts, are starting to come up in value a touch…they are ~2% more expensive than last week, but still priced historically cheap. But remember, there's a sh*tload of liquidity in ultra-short dated options, and as long as the marketplace can take these bets, what's the real need for longer dated hedges? Why not just wait until you need to buy the insurance?! (FYI, this works until it doesn't!!!)

• VIX Trades: large trades occurred that essentially bet that volatility will go up precipitously into March. FYI, with the current stance of option open interest, volatility can't really increase massively until the SPX is under the 4000 level.

• There seems to be a theme of bearish players buying some hedges early, and the bulls not giving a sh*t. Who knows what will play out?!

News/Reports

• The next big "number" is Feb 14th CPI (i.e. is inflation getting better or worse)

• VIX expiration Feb 15th

• Largest February OpEx (options expiration) on Feb 17th

As always, pursue the process NOT the profits!