Edit- this is the trade Echobay partners created and executed in 2006-2007 that grossed $97mm for the Fund where Vince Lanci worked. It is a classic example of what Vince likes to call “New Product on Old Asset Arbitrage”.
We list it here as it is key for advanced students of Option theory in understanding both the many ways money can be made as well as the risks of options.-VbL
NG EOO Arbitrage Summary
The following is the original trade idea as presented and executed in 2007. This was not a marketmaker strategy. It is included only as an example of thought process in managing option risk.-VBL
The Trade is based on a disparity between the conventional wisdom in current option modeling and statistical reality. In essence it is a function of current option models being incorrect in their assessment of the differences between American style options and their European counterparts as they relate to Early Exercise premium.
It exists for several reasons:
Commonly used option models do not account for the correlation factor and term structure in underlying commodity movement. They do not have a coefficient for other futures as related to the spot month.
Their valuation of Early Exercise premium does not properly handicap liquidity gaps, leptokurtosis, jump diffusion and skew for options.
The correlation between interest rates and Early Exercise probability should not be the most important determinant of premium in Commodity Options.
Early Exercise Defined:
Early Exercise is a function of Variation Margin in the Commodity markets. Variation Margin is a lending process that results from a trader’s inability to cross margin option profits with future’s losses as long as the option position exists.
Except for infrastructure and systemic risk, there is no material risk to the trader or his Prime Broker, but that Prime Broker may charge a fee for lending a trader’s own profits back to him for margining purposes. This phenomenon is tied to regulations in the industry.
Early Exercise Conditions:
An option is considered eligible for early exercise when all of the following criteria are met:
1-The in-the-money (ITM) option trades at parity with the future (100 delta)
2-The value of the equivalent out-of-the-money (OTM) option is less than the cost of borrowing on the ITM option
3-The theta of the OTM option is less than the cost of carry per day on the ITM option.
There is liquidity in the corresponding OTM option
If any of these 4 conditions are not met, then it will not save money to exercise the ITM option. Consequently, assuming the other side of the trade borrows money at the same or better rate, any option exercised early not meeting the requirements above will be a profit for him.
A sale of the American style option and a buy of the European equivalent. It is a neutral trade from a volatility and directional perspective.
Risks are minimal at the option level but potentially large at the systemic level.
The main risk is Early Exercise.
- Early Exercise is a function of interest rates, direction, volatility and liquidity.
- Interest rates- as these rise, money is lost in opportunity cost.
Early Exercise probability change is little to none
As the market moves away from strikes, their chance of Early Exercise increases.
- Volatility- As volatility decreases, the chance of Early Exercise increases.
- Liquidity- as liquidity in options with a less than 3 delta increases, the chances of Early Exercise increases.
- Strike Selection- little understood but very important, it is a function of leptokurtosis, Skew and mean regression as they relate to option liquidity.
- Diversification of Open Interest- the less counterparties there are on the trade, the more likely an “All or None” scenario for Early Exercise. Therefore, volatility of Early Exercise increases as number of counterparties decreases.
Exiting profitably is dependent on several factors.
1-Familiarity with the marketplace and its universe of counterparties
2-Familiarity with the nuances of the underlying commodity and its term structure
3-Option Risk management; A thorough statistical understanding of Early Exercise risk.
The trade payoff:
The Effect on the Parent Fund:
VBS Starts in 2012:
In 2012 the VBS algo is developed from gamma strategies employed successfully going back to 1993. It uses volatility regression as a means to predict futures trend expansion.
VBS is hugely successful with low risk reward and poised to raise capital as a CTA.
However the parent fund Vince worked for previously recruits him back for CSO market making. This put VBS on hold until recently.
VBS is a direct offshoot of understanding option volatility as a cyclical predictable product, and therefore relevant for future advanced classes. More another time.
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