No. of Recommendations: 4
> That means a lot of MM buying in the underlying stock (when call is bought)
Just noticed, I phrased this slightly wrong; too much time spent hanging around with 0DTE people. In this case I should say 'after' rather than 'when'.
Theoretically, for an market maker in options who is neutral w.r.t the market and wants to remain neutral and is profiting from the bid-offer spread: what follows is grossly simplified/naive but hopefully close enough.
Buying of the underlying stock when an out-of-the-money call is bought, should begin a little bit at purchase time, but the position in the underlying will mostly be increased/reduced over time depending on the time left till option expiry, and depending on the price of the underlying stock relative to the strike of the call, and also depending on the volatility in the stock price.
A way to think of it, is 'if this bet actually wins, I want to be holding the stock so that I'm not paying out the win from my own pocket'.
Thus, an amount of stock is held which is proportionate to the calculated risk of paying out. As it becomes more probable that there is a risk of paying out "it's getting closer to the strike price", "price movement is more volatile and thus likely to pass the strike price", "it's already over the strike and we're quickly running out of time for it to go below", the market maker should hold more stock as a hedge against further price movement upwards and increased cost to themselves at expiry.
The market maker would hold as much stock as is needed to perfectly balance the statistical exposure to the potential payout as the price changes, thus they are neutral w.r.t price movement in the underlying market and only profiting from the bid-offer spread on the options they sell. This balancing process is delta-hedging.
There are other ways to hedge against price movement rather than just buying fractional amounts of the underlying, e.g. buying/selling other options/stock.
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Anyway. Back to the issue of these young crazy men and women buying highly leveraged out-of-the-money calls with short expiry dates.
When the calls are first bought, the market maker hardly needs to buy anything when they delta-hedge. The stock price is far away from the strike and out of the money, the delta is low, i.e. the statistically expected cost of a pay-out is low / risk from price movement is low.
https://g.foolcdn.com/image/?url=https%3A//g.foolc...Now let's suppose lots of people are doing it, and suppose there is an actual small rally in the underlying stock.
Now, the MM is 'forced' to start buying the stock as the price quickly goes up, to cover the increased delta/increased chance of payout. Delta can be rising quite fast as the call goes from 'well out of the money' towards 'in the money'.
This effect is particularly strong at certain times of the month near to option expiry, when there is little time left for the option to move back down again.
My understanding is that all three effects can come into play at the same time. Market movements/stock movements can increase volatility; the price getting near to the strike rapidly raises delta; and if it happens near expiry the effect is amplified again.
However, as the payout danger starts to pass, and delta reduces, the market maker sells stock back to the market so that they are neutral again and they are not accidentally left with a net long position in the stock.
Likewise, if the call is sold back rather than exercised, the MM has some amount of delta-hedged stock they no longer have a risk of needing to deliver, so they sell the stock to remain market-neutral rather than have a net long position in the stock.
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This effect I'm describing happens all the time to some degree but it's especially potent with a) large amounts of b) highly-geared/well out of the money, c) 0DTE or short-term options.
Here, MMs do not have the statistical luxury of time to bring the price back down below strike. Also, many investors in a large group are picking the same stock, buying around the same price & time, and buying similar/same strikes and expiry. This amplifies and synchronises the effect.
Synchronised, forced, 'stock-agnostic' buying or selling is a potential source of unusual price movements both up and down. By stock-agnostic, I mean, the MM in principle doesn't have any view on whether the stock itself is junk or quality, they just want to stay neutral to the open bets and profit from the spread.
Like the old joke about sardines. Via Seth Klarman's book:
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"There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, 'You don't understand. These are not eating sardines, they are trading sardines.'"
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Why is 0DTE/short-term option gambling happening so much? Here is my theory.
a. It is very fun and sociable.
b. There is a very real element of skill and learning that improves returns.
c. It feels 'professional' or 'elite' compared to other forms of online gambling.
d. The casino's take is relatively small compared to the length of time having fun. In a regular casino, they have a small edge per game and they want you to bet very frequently. With 0DTEs, a couple of bets per day is exciting enough, like watching an unusually long horse race.
e. Option trading has been normalised and gamified by phone trading apps. IIRC Robinhood used to display confetti whenever you did something new.
f. It's popular, which makes it more popular - network or fashion effects.
g. There is no limit to the size or stupidity of bet that can be placed, no safeguards.
h. There is a lot of creative freedom in placing bets (choosing stock, strike and amount versus e.g. roulette or horse-racing or slot machines).
i. Some people are provably achieving incredible (often fleeting) success; it's all zero sum, but it all ends up somewhere. If everyone at the roulette table bets on a single number, someone always walks away rich (even if it's the casino owner). There is a tendency for the easily influenced to imitate community 'winners' in hopes of imitating their past success.
j. With options, upside is unlimited, downside is limited. This is very appealing.
k. Being real: for many young adults there is *no prospect whatsoever* of ever owning a house or being able to afford a family, no matter how hard you study or work and save. I'm in my 40s and many of my friends with STEM MA / PhDs are still unable to buy a house or have given up hopes of having kids due to the costs of childcare. I know several dual PhD couples for whom the last 15 years has been an endless nightmare struggle, despite moving out of academia to industry. When the pace of house prices increasing exceeds your capacity to save, you are simply screwed. When the cost of childcare per child represents a huge fraction of one of your two incomes, you are simply screwed. If people like us still can't buy houses or have kids, despite the highest level of education in valuable, high-demand subjects, and saving hard - what sort of chance has anyone else got? (unless they have rich and generous parents)
Since hard work does not result in even modest success in life any more, just relentless grinding poverty, many young people turn to this form of 'educated gambling' as a source of hope that their lives might not be completely dreadful forever. Combined with the proof that it *can* be done by some people, it's a huge temptation. For some it may even be rational when there is simply no other hope of getting somewhere in life.
"Perhaps I can use skill and a little luck to escape my personal hell". It's a bit like when desperately poor people start buying lottery tickets, except now, for 'young' adults (<50), almost all of us are 'the desperately poor'.
lux
