Using The TSLA Price Endgame To Understand Options - Party at the Moontower
editor	Newsletter Thoughts, The Money Angle	 7 Nov 2021 7 Nov 2021 12 Minutes	
I’ve discussed this topic in more detail: Structuring Directional Option Trades
It actually might technically be the midpoint of the spread that you are said to be getting odds on but I can’t regenerate the proof, so I will wait for someone smarter to enlighten me.
If I buy a call option from you, and you hedge it by buying the stock, we can both win. The loser is the shareholder who sold you the shares you bought to hedge. Option traders do post-mortems by decomposing the p/l. In this case, the decomposition would show I won more on the option’s delta than I lost on the fact that the volatility wasn’t as high as what was implied. Here’s an example:
Suppose the stock is $100.
If I buy a 10% OTM call for 2% premium and the stock goes up 13% by marching higher a mere $1 a day for the next 2 weeks, I’m going to net a 50% return on my option.
The market-maker who sold me the option is going to buy a little bit of stock every day to hedge the short call. (This example is a bit opaque because the amount of stock the MM buys depends on the option delta which depends on the vol. They call it “dynamic hedging” for a reason)
If the MM hedged the call on a delta derived from a vol that was higher than what was realized, they are going to make a tidy profit themselves. The only loser is the shareholders or shorts who sold the MM the shares they bought to hedge.
(For exposition, I’ll point to an extreme scenario…the implied vol goes to 0 and stays there after I buy the call. In that case, the call option I bought will get marked at zero and the model will assign it a 0 delta. The MM will not hedge by buying any shares. In that case, the shareholders are totally out of the picture, and I will make 50% return on my option at expiration and the MM’s loss will be the exact mirror image of my gain.)
The largest option market-makers all hail from the same Philly-suburb-lineage. While their official market share numbers would be distributed, the mental market share is far more concentrated. Jane Street, SIG, and Citadel don’t stay in business by trying to outsmart each other. The trope of the 5 sharps and 1 whale at the poker table is apt. Everyone gets a bite even if they wrangle with each other a bit.
“Willing loser” is a term credited to investor Charley Ellis. Coming from the commodity markets, I viewed hedgers as “willing losers”. The covenants in their lending agreements require them to hedge the price risk of the stuff they pull from the ground, which makes them relatively price-insensitive. Ben Carlson gives more examples of “willing losers” here.
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3 thoughts on “Using The TSLA Price Endgame To Understand Options”	
kishoremarodia says:	
Another master piece, thanks for insights. One query – Since Call/Put needs to follow a parity, how does one visualize looong right tail? Wouldnt call put parity ensure the tails are always evenly distributed, there might be some amount of skew, but not much.
I may not have correctly expressed it. Eg: If people are expecting a beat from MSFT before the results, and expressing it with buying calls, the call sellers bid up the IVs. However with PUT/CALL parity, even the PUT IVs start bidding up.
That’s right. The call and put IV should trade at the same vol although to any observer it may not appear that way if they price the options using a funding rate that differs from the market.
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