InvestIdeas

Conversions and Reversals
every last but one Fri of the month, across the board, stock volume transactions rise above average daily transactions. why does this happen?

most people will cite that it is because it is this day that equities and index Options and sometimes Futures expire... but so what that these derivatives expire?

why is it that when these derivatives expire, the overall trading volume of equities markets rise? aren't these derivatives separate classes of assets that can be traded independently from stocks, nevermind the existing relationship? who is to dictate that i must buy or sell stocks when i trade options? for most options traders, they take positions in Options without accompanying stock positions; such as Long Call, Short Put, etc and hence liquidating those options on expiration day should have no material impact on volume of stocks traded. of cos, those who BUY/SELL-Write (eg, Covered Calls, married Puts) will likely close off their stock positions as they square off their Options as well. but these are arguably a significantly smaller group in the Options trading space. consequently, their overall trades should not consistently rake up the increased volume that we witness on every expiration day.

so, then, why do stock market transactions volume spike on such expiration days?

the answer lies in Conversions and Reversals....

simply explained, a Conversion is a Long stock AND a synthetic Short position; for example :

say AAPL is at $200 now.

Long AAPL @ $200 (this is the Long stock position)
Short AAPL 200 Call + Long AAPL 200 Put (this combo is the Short synthetic stock)

If stock price moves up, the Long stock position profits but the Short synthetic stock position loses about the same amount, resulting in very little fluctuation in the P/L.

Conversions are as good as flat positions (not totally, but very close). Hence, there is no directional risk in Conversions.

since Conversions can hardly make money (not that it can't, just rather difficult), the question that is begging to be asked is "why would anyone establish a Conversion?"

answer: no retail player in the right mind, except to temporarily mitigate all directional bias risks, should establish such Conversions.

but this doesn't yet directly explain why Conversions and Reversals cause stock markets activities to spike on expiration days...

Prof KNN, nice discussion. Pray tell. I am all ears.

to truly understand the cause of volume spikes on Option expiration days, we must comprehend the Put-Call Parity structure that is associated with Conversions and Reversals.

recall an earlier discussion about Put-Call Parity equation. in a gist, a Put is a Call and a Call is a Put. if this sounds confusing, you are on the right track

Put-Call Parity
Call = Put + Stock - Strike + Interest - Dividend

and by rearranging this formula,

Long Stock = Long Call - Short Put + Option Strike Price - Interest (carrying cost) + Dividend (of stock)

in otherwords, any Long stock position can be synthetically created by using Options and using some combination of Options, Long or Short stock positions can be synthetically created. now, this is a powerful tool and knowledge.

Market Makers (MM) seize this knowledge to their advantage. In fact, Conversions and Reversals are strategies utilized by market makers every trading day. they have to do so, because they have to accept all orders, both buy and sell. in order to make a profit, they cannot always choose only to buy or sell. almost all market makers will buy and sell throughout the trading session. one of their primary functions is to provide liquidity and get rewarded. however, at times, they find themselves too Long or Short, and risks mount. to defray risks, they "convert" their stock positions into synthetically opposite trades. by doing so, they remove directional bias without having to liquidate existing stock positions yet.

so, if a MM is uncomfortable being too Long XYZ at $100, he/she will immediately Long 100 Put and Short 100 Call to form that Conversion. the MM "converted" his Long stock position into synthetically short stock position, removing his directional risks.

now, come that Friday expiration, the synthetic Short stock (Long Put and Short Call) position could well need to be exercised, if XYZ falls below $100. the market makers does so and automatically, that Long XYZ stock gets sold in the open exchange. even if XYZ price was higher than $100, the fact that those options are expiring, exposing the MM with Long stock directional risks, these Long stock positions will be liquidated. this action contributes to the increase stock volume transactions. MMs are in the business of speculating market directions.

the same can be explained about Reversals, which is

Short Stock + Long Synthetic Stock (ie. Long Call + Short Put)

on Option expiration day, if those Long Calls are exercised, the relevant Stock will be purchased.

retail players do not usually enact Conversions and Reversals. only MMs do so, in order to profit from

a) buying the Bid and selling the offer
b) arbitraging the difference in price of direct stock purchases/selling and synthetic shorts/longs
c) interest rate outlook; conversions are interest rate bearish and reverses are interest rate bullish strategies

these advantages above are very tiny, sometimes less than 5 cents but due to the size of their transactions and very low to near zero commissions on trades, they can make substantial profits if they get them right.

MMs are by far the single largest contributor to stock volume transactions...retailers, commercials and in-house traders trade with them.

so, please don't try Conversions and Reversals unless you are fully aware of the intricacies involved...

and so, now we know the reason for the consistent Stock volume spikes on Option expiration day...because Conversions and Reverses are closed off by MMs.

Stock Dividends and Its Impact on Options

Although dividend is not a Greek component of any Option, it has a direct impact on the values of Calls and Puts. For this reason, it is important to understand how dividend payouts positively or negatively impact Option values.

I will refrain from a lengthy post on this topic, in part because I'm still struggling to understand the technicalities myself.

Aside from the actual reasoning and explanation of how dividend payouts affect Calls and Puts, it is at least important to note this general phenomenon.

On Ex-Div Date (commonly known as XD to Singapore traders/investors) :

a) ITM Call values will be lower
b) ITM Put values will be higher

Deep OTM Calls and Puts will largely be unaffected by dividend payouts.

It is also for this reason that a day before XD, open interests and trade volume for these ITM options will see gigantic spikes. It has nothing to do with market place opinion on direction of the underlying price movement. Thus, trying to decipher the directional bias based on open interests of the Calls and Puts in especially just before XD will be misleading and inaccurate.

If there's anyone who can succinctly explain this phenomenon, please post here. My brain is all jammed up putting together the details of this outcome. Thanks in advance.

Option Strategy During Earnings Season

Very often, stock prices can gap up or down on the next opening session, immediately after quarterly earnings are announced. Such directional risk can be largely mitigated by using the underlying Options.

For example, AAPL is announcing its quarterly earnings today after bell. You had earlier Shorted 100 shares of AAPL at $200. Of cos, if you now have an opinion that AAPL may release a set of sterling earnings, you may choose to close off your Short position and that would totally remove all risk. But with no risk, comes no possible rewards.

Since you are already Short 100 shares of AAPL, you want to maximize your potential for profits but remove as much directional risks as possible. Just in case, AAPL gaps up on open the next morning, as a protection, you can establish the following Option position :

200 of Long $200 Call Options

By having Long Calls, any upside gaps next morning will protect your Short stock positions.

Hang on... you only Shorted 100 shares of AAPL, so why buy 200 of AAPL Call Options when 100 seemingly would suffice?

The answer lies in one of the Option Greeks, namely Delta.

At-The-Money options possess 0.5 delta, whereas 1 Short share of AAPL has -1 delta. Therefore, you need 2 ATM options (2 x 0.5) to equal 1 stock share.

Portfolio Recap :

Short 100 shares AAPL @ $200
Long 200 $200 Call Options

GREEKs Profile :

Delta : 0 (Short 100 shares = - 100 deltas, Long 200 Call Options = +100 deltas)
Gamma : +0.06
Theta : - 0.24
Vega : +0.40

Note that Delta is 0, which means you will not gain or lose no matter how AAPL price moves the next morning. You have effectively removed directional risks arising from earnings announcement. At least this is how it will appear.

In reality, Delta of these 200 Call options will change, when AAPL price moves away from $200 mark. The Delta will change because of Gamma. The overall value of the Long Call will also be affected by Theta and Vega, which are also NOT zero.

If you were Long 100 shares of AAPL, then by going Long 200 options of $200 Puts, will achieve the same direction neutrality to your portfolio. The overall Delta will be again 0, and the remaining GREEKS will largely be the same as above.

We can discuss the impact the remaining Greeks have on this portfolio later. Please feel free to chuck in at any time.

But for now, you can appreciate that using Options, you can immediately remove a chunk of directional risks, without having to liquidate the stock position.

Delta Neutral Positions - The Earnings Season Play

The question I asked myself when I first came to know about Delta Neutral plays was, "Why even bother to put up with such a position?"

Maybe you too have the same question in mind, when you consider the oxymoronic combinations of Stock and Options positions. Recall our AAPL example.

AAPL price at $200
Short 100 shares of AAPL at $200
Long 200 options of AAPL $200 Calls

By establishing this position, it has 0 delta ! Any position that has a combined 0 delta will not increase or decrease in overall value when the underlying price moves. That is, if AAPL moves up by $1, the Short 100 shares will lose $100, but this is mitigated by the Long 200 Calls, which will roughly gain $100. The net effect is almost $0 profits or loss due to 0 delta.

So, why even bother to establish this trade?

But there are traders, and particularly Market Makers, who will put on such Delta Neutral positions. This is why.

(wait..i go smoke first...BRB )

Overall you may not still be fully hedged.
You have assumed option cost to be zero; or interest income from the short share position is equal to cost of call options. This essentialy means the call options are priced in only risk free rate with zero intrinsic values. When market is efficient, expecting good results of the company to be announced, the call options cannot be priced at zero intrinsic values.
Incentive to do take such a position is only if you have a very large portfolio of short positions and covering this large position is dammed costly (prices will go up very fast and transaction costs are large) and time consuming (maybe low liquidity in stick trading). Then it is still worthwhile to spend the transaction cost.
Am I correct ?

thanks for the response..i was beginning to think i'm speaking to myself here

i can attune to your invaluable comments .. my thoughts are below :

financecaptain wrote:Overall you may not still be fully hedged.

i agree totally. in essence, there is no such a concept as a perfect hedge. the only time a position is totally riskless is one that is liquidated.

financecaptain wrote:You have assumed option cost to be zero

the price of the ATM Call is indeed a cost. however, in the context of establishing these Long Call options to Delta Neutralize the Short stock position, it is lesser relevant as such a combo position is not meant to be held for anymore than 1 day, the day after the earnings results are announced...as such, once these Long Calls are liquidated, the cost of establishing them, would largely be recouped, except for the cost of 1 day time decay..

financecaptain wrote:or (You have assumed) interest income from the short share position is equal to cost of call options. This essentialy means the call options are priced in only risk free rate with zero intrinsic values. When market is efficient, expecting good results of the company to be announced, the call options cannot be priced at zero intrinsic values.

first of all, all ATM options do not possess intrinsic value. all of the premium of ATM options, both Puts and Calls, are totally extrinsic; ie. time value... in our example of $200 strike Calls, the premium, in part represents the carry cost which is the current interests which would have to be paid for borrowing sufficient money to purchase 100 shares of AAPL for a period of time.
this incidentally will lead us to the discussion on why Market Makers will establish such Delta Neutral positions.. but I like to separately articulate this point at a later time. it can be complex if the financial fundamentals are not first expounded.

financecaptain wrote:Incentive to do take such a position is only if you have a very large portfolio of short positions and covering this large position is dammed costly (prices will go up very fast and transaction costs are large) and time consuming (maybe low liquidity in stick trading). Then it is still worthwhile to spend the transaction cost.

the reason for establishing Delta Neutral position is the same whether for large or small position size, which is to remove a very substantial amount of directional risks.. the concept of this Delta Neutral play is not just only to remove directional risk, but in essence to possibly gain from the fluctuation in Implied Volatility associated with the accompanying Call options... no one should aspire to get into a delta neutral play if the possibility of making money is not present. if so, it would have been better off to liquidate the Short position in its entirety, saving the additional cost of transactions in purchasing those Long Calls and fully removing all delta(directional) risks inherent in the Short stock position arising from the expected wild price swing posed by earnings results.

Thanks again for patronizing this discussion.... i feel so alone here ...hahahaha So, do come in more often... fresh ideas, fresh critique...

Hi k ge, have you tried cross-currencies digitAl options? Is it available retail investors? and what is your opionion for this kind of products as I think it is OTC if I not wrong. I think payout is gd but goalposts aka spread is usually narrow.. Not easy to score goals..