the art of paranoia

Friends,

This is a fun one.

A good friend and mentor from the pit sent me this (lightly edited and hyperlinked):

I was catching up on moontowers and reading your cotton story. Made me think of one that you can use if you ever cover interest rates.

I started in trading with silver options. I was quite meek as I had never clerked. I was just backed and thrown in the pit at age 22. Anyway, a couple of years in, silver had rallied from around $4 to $7. The whole pit was short long dated $4.50 calls to a spec who was holding the long. These things were easily exercisable as interest rates were high. Great short to have.

Broker [badge redacted] (you may remember him) offered the synthetic put at zero. No one knew what he was doing. I bid 2 ticks under and he said sold.

So I said “1000”. I think the biggest trade in that pit was like 200.

Anyway I took 1000, exercised them and made 10 grand before commissions. The carry was probably north of 50 ticks and he increased his shorts by around 800 as all the other locals got hit with my exercises. The other locals were pissed.

So I came in through a broker and bid 2 ticks under the next day. Locals hit me. I got lucky because I was clearing [redacted prime broker] and they neglected to put in my exercise. They delayed it by mistake (and gave me the interest as I recall.)

Anyway the locals thought they found someone who would hold these things and just wanted a synthetic put for a credit. I kept doing the trade for a week.

[Redacted broker] got it right by the second day. I think I made another 5 or 10 grand before the locals figured it out and stopped doing it.

Anyway. I hope if you relay this no former silver option traders subscribe. They still don't know it was me!

There’s a lot going on here!

Option pricing mechanics, pit dynamics, deduction.

Let’s start with the option pricing.

I don’t want to deny you the opportunity to figure that part out for yourself.

In the following list, I’ll start with important clarifications but as the list unfolds the material is more of a hint than just reference information.

Like a quiz show, buzz when you understand why “locals” [ie the other traders] were willing to” sell 2 cents under” and why my friend was willing to buy that level.

Clarification and hints…

• 1 silver option references 1 silver future. This is typical in commodities whereas equity traders are used to an option having a multiplier of 100

• 1 silver future references 5,000 troy ounces of silver. So if silver is $10 an oz, it’s a $50,000 contract

• The minimum increment, or “tick”, in silver options is .001 or 1/10th of penny. Since it references a 5,000 oz contract, a penny is worth $50 and a tick is worth $5.

• This story happened many years ago. Look at those silver prices: “Silver had rallied from around $4 to $7. The whole pit was short long dated $4.50 calls to a spec who was holding the long.”

• Silver options are American-style meaning you can exercise them anytime.

• “Random assignment”: when an option is exercised, any contract in that series held short is equally likely to be assigned regardless of the clearing firm or account. See rules.

• When a broker quotes a “synthetic put” (and yes synthetics are not just identities but directly traded orders!) the convention is to bid or offer as a “differential to intrinsic value”. When my friend bid “2 ticks under”, it’s understood that he’s willing to pay 2 ticks under “intrinsic value”. If the futures are $7 and the broker sells the $4.50 call 2 ticks under than the trade package is:

• While futures are subject to initial and maintenance margin, option premiums are settled in full. In other words, the premium is not itself marginable. That is normal but worth stating because there are some option markets where the premium is marginable (ie WTI options on ICE)

At this point, you should be able to understand my friend’s side of the trade. If you don’t want to bother, stick around, I’ll spell it out soon enough but also that part should feel really obvious to anyone that’s ever owned an American option.

The harder question is:

Why were the broker and the other locals willing to sell him the synthetic put 2 ticks under?

Your last hint is a line already tucked into the story:

The whole pit was short long dated $4.50 calls to a spec who was holding the long. These things were easily exercisable as interest rates were high. Great short to have.

This is fun stuff. Let’s unpack it.

continue at moontower.substack