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30 August 2017

Why Do They Always Sell Options?



Why do they always sell options? Over the years, I’ve come across too many LME users who alight - often believing themselves to be uniquely far-sighted and smart - on the notion of selling options, because the premium makes a nice income, doesn’t it? In the days of relatively unsophisticated position management software, it used to be so easy. Low delta options look benign, with their seemingly limited exposure. But they're pesky creatures, and it doesn’t always take much to change that delta so that they suddenly look a whole lot riskier. The alarm bells often used to ring too late…

I recall a time in the late nineties when the man running our Japanese office discovered a newly-promoted young trader running a part of the copper book at a very reputable trading house. “Come and meet him,” he said. “If we act first, we can steal a march on our competitors who have not yet realised his new position and potential.” So off I went to Japan. I knew the new man’s boss pretty well, from the past, but apart from a brief chat with him, we focussed on talking to the new boy. I guess I was guilty of ignoring some of the signs, when, sitting down next to me at a very smart Tokyo restaurant, he announced: “I am the new Hamanaka in the copper market.” Well, that should have seen me back on the aeroplane before the first course was served, but it didn’t. I just filed the comment as youthful over-enthusiasm. After all, it was a prestigious house, I knew and respected the overall head of the trading; what could go wrong? 

Well, to begin with, nothing. Our man traded happily, sometimes winning, sometimes losing. It was a speculative account, not directly connected to the company’s hedge requirements, but that was their decision. After a short time, though, our man started to sell options - in big volume. It helped our monthly numbers look really good, and we were reasonably comfortable, as our software was up to date and tracked position changes accurately. They were a big counterparty, they had a big credit line. So on it went. 

Then things started to go horribly wrong. The Japanese company belatedly saw the size of the implied position as the market moved against them, and were not happy. It far exceeded the limits under which the trader worked, and they asked me to go to Japan to talk it through with them. Well, actually, my input was small to that discussion. Although they didn’t like it, they paid up what they owed; the trader in question was relieved of his position, and soon afterwards of his employment, and his boss, the man I’d known for a long while as an impeccably-behaved trader, also lost his job. And why was all this? I would say, because they thought selling options was an easy route to large profits. Because, of course, you’ll always be in control of what the market does, won’t you?

A few years later, I found myself sitting with my Taiwan representative in the office of a very smart, very neat scrapyard just outside Taipei. The man running the international trading - the son of the owner - was well known to us. He had worked for us in our representative office, when both of us had been working for a different company. These people were big players in the scrap business, pretty sound, very rich. Nevertheless, they knew they had to deposit lots of cash to secure any credit. So they did, and the business flourished. But it was based on selling options against the piles of scrap sitting in the yard. That was OK, but then the LME position began to grow, until it dwarfed those piles of scrap. Our friend was a canny trader, and he kept it going for long while, selling us thousands of lots of options every month. It generated lots of money for us, but in the end, the tail wagged the dog too vigorously, and all came grinding to a halt. We got most of our our money back - slowly - and our  trader branched out into property development, always a favourite in Taiwan. Again, an example of how managing those short option positions eventually gets too much.

It’s not only traders, though; round about the turn of the century, we dealt with a large European manufacturer of electrical switchgear. They were a natural buyer of copper, but understanding how volatile the market could be, and given the long lead times of some of their products, they decided they would rather buy call options than outright positions as their hedge. Very sensible. However, they didn’t like the way they had to pay cash for them, so they decided to sell puts simultaneously - a good old min-max strategy. They made it clear that they were happy, because if the market went down and the puts were exercised, well, OK, they had to buy anyway, so all would be fine. Mmm.… That one always sounds good, when the market is far from the strike level. In reality, though, as the price went down, and down, and their puts sunk further and further under water, they decided that actually, this wasn’t such a good idea; surprise, surprise, they didn’t want to be long above the prevailing market after all, despite their earlier assurances that all would be well. They would have to restructure their hedge. Well, to do that, you need to lower the strike price, but to avoid cost, you also need to increase the volume. Great business for the market maker, not so good for the consumer if the market keeps going down - which it did - and the problem just gets bigger. Eventually, they decided to square it all up - fairly expensively - and give the LME a miss for a while.

So is there a moral to theses tales? Probably more of a warning, that what seems an easy flow of option premium income carries in it the seeds of its own destruction - I’ve not known many people who have sustained the strategy for that long; and I’ve also had personal experience of how the greeks gang up on you overnight, just when you thought it was safe to sleep. (For the absolute avoidance of doubt, that’s "greeks" as in mathematical functions, not “Greeks” as in Mediterranean people.)


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