-
Whoever sold that very out of the money call option (hence the cheapness of it) would have hedged themselves properly, both in the underlying at the time, and the volatility as soon as it started to look a bit funky, over a year ago. Come expiry, they may have to faff about a bit to make sure that they stay delta hedged, but it's not going to be a huge concern.
Just a curious (and almost totally ignorant) bystander... can you explain this in simple terms please?
This is fun to watch and all, but surely at some point everything goes back to normal... the kids on Reddit who sunk their student loans into this loose their nerve, everyone begins to sell, the stock crashes back to normal levels, the hedge funds make all/most of their money back by shorting on the way backdown and a ton of kids caught up in the hype loose their savings?
ewanmac-
Just a curious (and almost totally ignorant) bystander... can you explain this in simple terms please?
I can try! It's a simplistic view though.
When you sell an option, you give someone the right, but not the obligation, to buy (call) or sell (put) an amount (the nominal) of something (in this case equity / stock) at * or before a certain date (the maturity), at a certain price (the strike).
When they do this, they are exercising the option (or just letting it expire if, for example, the price that are able to buy at is more expensive than the price in the market)
The value of that option is determined by a number of factors - the current cost of the stock, the expected future cost of the stock, the risk free interest rate, and the volatility of the stock, how much it moves up and down over time.
You use the value to determine the price paid, and also to determine how much it is worth day by day - you don't just wait until the option is exercised to discover how much money you have made lost.
What you can also do with the option pricing model is determine your sensitivity to the price factors - how much is the option worth if the stock price moves (this is the delta) or if volatility changes (this is the gamma).
There are other measures, but these are the ones most cared about, particularly in this scenario.
Going back to when you sold the option. Let's say you sold at a strike which was the same as the current option price (let's ignore interest rates). This is called an At The Money option.
The delta of an ATM option is 0.5, near enough (for puts or calls - they are the same at this point - but you have sold a call). What this means is that if the stock price moves up, you will stand to lose money.
But you're an option trader - you trade volatility. You don't want to be worried about the actual stock price, so you hedge your position by buying the stock. In this case, you sold a call, so you need to buy the underlying - and the amount you need to buy is the delta times the nominal.
So end of day 1, you position is
- minus 1 option to sell 100 units of Something for $10 in 12 months
- plus 50 units of Something
- plus cash for the sale
Every day, you re-mark your position, and buy / sell the underlying according to changes in stock price & volatility.
Simplistically, this will mean that you are losing the money you were paid as a premium, as you will be buying when the price goes up, and selling when it goes down. As the seller of volatility, you want the price to stay the same (i.e. not be volatile).
What this means is that when the buyer exercises, it doesn't really matter - you've already realised the losses.
Out of the money options are when the strike is miles away from the current or forward price. This makes the current value of the option very low. They are usually used for very specific hedges or insurance, as YOLO trades (cf. Deepfuckingvalue), or someone has spotted that they have been mispriced (cf. my comment about Goldmans)
The principal about portfolio / position management remains though - you're managing the position every day, all day. You don't get surprised by someone cashing in an option 12+ months after they bought it. You say to yourself - the price of this option that I sold is going up and up. I'm going to realise my loss right now and close it out (by buying the same / similar from someone else).
** more common in interest rate & currency options
- minus 1 option to sell 100 units of Something for $10 in 12 months
NotThamesWater
The cost of carry is lessened by the interest on the cash paid for the security sold. (In theory, there is a relative parity between the repo rate and the cash interest rate, depending on risk etc...)
We don't know the tenor / maturity of the repos that Melvin bought to cover their short position - if they bought long maturities, they're not going to be paying a coupon on the current price, but the purchase price.
If they are buying rolling short-term repos, then they are, as you say, paying a massive amount away.
The lender / repo seller, however, can make margin calls - I'm guessing this is what Blackrock has done. They can see the price shooting up, and their credit risk guys are shouting out that Melvin is breaking limits, and need to cover the debt.
This is where Citadel comes in with a financing deal that helps themselves to a chunk of Melvin's portfolio (for cheaps) and an interest in stopping other people making their new portfolio tank any further (through blatant market manipulation and other dirty dealings).
Whoever sold that very out of the money call option (hence the cheapness of it) would have hedged themselves properly, both in the underlying at the time, and the volatility as soon as it started to look a bit funky, over a year ago. Come expiry, they may have to faff about a bit to make sure that they stay delta hedged, but it's not going to be a huge concern.
Market makers got burned by the Goldmans of this world 10+ years ago when it comes to out of the money options.
(Caveat - I'm rusty af on all this stuff)