Malt Liquidity 16
Ali Baba and the 40 Weeks to Expiry
The Bourne Delisting
I spent the last few days talking about a relatively mundane story of the ICE CEO unable to placate any of the parties with varying interests and near-expiry political stewards with regards to the delisting of a few Chinese telcos. However, a more interesting delisting scenario is the potential (though unlikely) delisting of BABA, namely due to the high degree of open interest (OI) in the 11/21 monthly call options at the 260 and 450 strikes (among others). Why the November monthly? Well, originally the plan was to allow the 3 stocks being targeted by ICE to trade until then, given that the executive order specifically allowed until November to wind down positions. This risk theoretically is reflected in the stock in a pretty straightforward manner - the stock price would be a function of theoretical capital growth up until the trading halt discounted for some sort of liquidation risk, plus inclusion of the probability that the trading halt is undone - but options do not move linearly, so assuming the trading halt would go into effect at the beginning of November, naturally, the policy risk would have some interesting effects on the monthly November and later-dated options relative to the short term options, which should have a heightened volatility premium solely due to the potential of news shocks sending the price jolting up and down. There’s a lot to account for, but essentially all of the political risk will be accounted for in the implied volatility of the option and will adjust accordingly with the realized volatility going forward. It naturally follows that implied volatility would be elevated by a factor of the probability the policy holds from the historical volatility it would be normally priced at, and this would continue to tighten to realized volatility going forward. However, there are two confounding factors as to how I’d practically think to trade this relative to what this paper states (which would get an official citation, but hey, this is a blog post):
The paper concludes (which intuitively I agree with, and the math seems to check out) that implied volatility and historical volatility will converge going forward, though this is correlated with the perception of political risk increasing or decreasing, and the speed of the convergence potentially being dependent on how fast this risk can be assessed. It also states that the term structure of the volatility curve involves some of the ‘peso premium’ effect - that if nothing happens, the price of the underlying will drift upwards. I mentioned practical confounding factors, though:
I don’t see “early exercise” mentioned anywhere in the model, as they seem to price strictly European options (which cannot be exercised early), which makes sense, as from an academic standpoint, American options (early exercise allowed) generally do not have a material effect on the math
The paper deals with at the money options - how would this work for in the money options? There is plenty of OI in the aforementioned November monthlies ranging from slightly to deep ITM
These points tie together in a fairly peculiar scenario. The November monthlies have an extra 18 days of theta (time to expiry) caked in from November 1 as they expire on the 19th, but if I don’t expect the stock to be trading past the 1st on the revised policy, this should be discounted as well. This should also happen to the delta sensitivity in deep ITM options, which behave closer to a stock than any other option - perhaps you’d see delta convergence along with volatility convergence between the November monthly and the end of October expiry, but clearly delta behavior will be skewed in some manner to account for trading halt risk, and that there might be a scenario where you’d want to exercise early if spreads are too wide and liquidate your position through straight equity, though I’m partially assuming that the person short options is hoping they expire OTM (and I’m not going to entertain what happens when the clearing house literally can’t enforce assignment/reconciliation due to “national security concerns”.) Oddly enough, I am reminded of Sloan v SEC when I think about what happens to options where the trading is just halted indefinitely in a stock.
So how is this actionable? (Disclaimer: not financial advice) Note that option spreads are a reflection of the stock’s general liquidity, as market makers have to account for slippage risk - therefore, the raw stock will have some sort of liquidity premium when everyone needs to sell their position. When people will start taking profits or brokers will start closing out positions is also unclear. While in this case, the policy is an executive order and thus can be pretty easily undone, in general it’s probably necessary to speculate on whether the news is a) accurately reflecting the odds of the policy sticking and b) whether the market is over or under-reacting. If you think the market is overreacting, you could short the convergence of the post and pre trading halt options (long the later expiry and short the front expiry), and vice versa for the inverse, and if you don’t want to be exposed to price, you can hedge the delta difference (which, this far out, should be somewhat discounted) with stock.
(Note that you could also be net long/short on price exposure by making these spread trades, rather than at the same strike, and not hedging your delta)
Of course, one could note the similarities of convergence trading on political risk with infamous cases like Long Term Capital Management (who actually employed the Nobel Prize winners who came up with the modeling formula most option models, including the aforementioned, are based on) blowing up on the Asian crisis, but these kind of opportunities where speculation can be done with a small bit of edge exist everywhere if you know how to find them. Note that it’s also much easier to make these trades with small sizes, which, in markets, can be up to low 8 figures, than with Buffett-sized capital. The curse of size in markets is that it’s not really worth making a few hundred k on a portfolio in the billions, and that a lot of these tiny edges are tiny because you cannot simply scale them up - there has to be sufficient liquidity.
This is probably the most speculation I’ve done in this newsletter yet, and I’ll shamelessly plug my twitter (that I now use) for discussion and critique - I’m sure there is plenty more to expound on, given that the list of affected Chinese stocks is expanding.
Yes, your collection of popsicle stick jokes is still worthless
In Russia, insurance fraud consists of capturing people jumping in front of cars that have dashcams, and in Japan, fraud consists of forging popsicle sticks to try and redeem them for special edition Pokemon cards apparently:
Takashi Ono, 43, is suspected of attempting fraud after he sent 25 fake popsicle sticks in November last year to confectioner Akagi Nyugyo Co. in Saitama Prefecture, according to local police.
The company ran a competition between June and July last year in which people could send in rare lucky sticks from its popular popsicle brand Garigarikun in exchange for Pokemon game cards created for the event.
The limited sticks were engraved with the words “You win a Gari-Pokemon card,” which could only be seen after consuming the ice cream.
Akagi Nyugyo contacted the police after receiving multiple lucky popsicle sticks from what was believed to be one person, local police said.
Much like being the only buyer of short term call options is indicative of something shady, turning in multiple winning “rare” popsicle sticks without knowing the actual probability of winning most likely indicates fraud. Perhaps the popsicle contest speedrun committee will document the proof beyond 1/1 trillionth of a doubt that Takashi couldn’t have accumulated these sticks through pure luck.
On that note…