Straddles and Point Spreads

With the Superbowl one week away, office betting pools are in full swing. So are all the online betting sites. While the Superbowl brings in all sorts of weird and quirky side bets, like who will score the first touchdown and how many field goals will there be in the game, a majority of the money is still placed on the good old fashion line.

Currently, the line is the Patriots – 6 ½. It always amazes me that many people still think this line is a prediction of the final outcome. Well, for starters, for those of you that don’t follow football, it’s not possible to win in half points. So that should be one clue. And many times you will see even lines, meaning the spread does not favor either team. Clearly, the odds makers are not suggesting a tie are they?

No, the line is meant to measure sentiment, not the actual final margin of the score. Then people will always ask me, why would they do that? Why would the odds makers make a line that they feel is wrong, just to bet on sentiment? Well, the odds makers are trying not to bet at all. They are trying to actually create a line that if correct, will generate the most amount of two way action. If they can accomplish this, the casinos who take the bets, need not worry who wins the game and by how much, but rather they can collect the 5% juice, as it is called, from both sides. Juice is like a commission. Kind of the way a broker makes money on every one of your trades whether you make money or not.

So what does this have to do with options trading you begin to ask? Well, it’s important to understand that the same dynamic that is used in the prediction of sports lines, is also used in big events on option prices. Although many academics may disagree with the notion that option prices are attached to sentiment, rather then rigid quantitative pricing models, the truth is, it’s probably a little bit of both. I just chose to explore the idea a little further to help others gain a better understanding of option prices before a big news event such as FDA approval let’s say.

Many people always ask me, John, how do the market makers price these options ahead a major move, when they don’t know which direction the stock will go in, or how big the move the will be? The answer, like the odds makers in Vegas, is sentiment. Most MM’s have a general idea of the range of prices that the stock could trade up to or down to after the news, but the MM’s are not interested in making a bet on the outcome of the move, they are interested in the same thing as the casinos in Vegas for the Superbowl, they want to earn the juice or the spread on both sides.

How do they do this? By making the option prices attractive to both the premium buyers and the sellers at the same time. If the option prices are too cheap, everyone will buy them and cause the MM’s to have to take the other side which they don’t want to do. If the option prices are too expensive, everyone will be selling premium to the MM’s and again, the MM’s will be making a huge bet that they rather not make. So the MM’s move the option prices accordingly to get the most two way action. This allows them to stay delta neutral and more importantly, gamma neutral ahead of a large and unpredictable move.

Now this creates an interesting situation. As the option prices may not reflect anything near what the final outcome will be, but rather just what the public feels the outcome will be. For the options speculator, this can create very profitable opportunities to bet against the public and reap huge rewards.

For example, during the past year, the option prices on all the FDA stock events have been substantially undervalued. People would ask me, well why then are the option prices not more expensive, don’t these MM’s ever learn? Actually, the MM’s made out very well I’m sure because the prices, which may have been undervalued, created enough two sided action.

Even if the MM’s knew how just how much a given stock would move on such news, if they priced their options accordingly, they would be so high that most of the public would be net sellers and no one would be buying. If the MM’s were wrong, not only would they lose their shirt, they would lose their seat on the exchange and probably their house and their life savings. No risk is worth that.

So the option prices traded far below their eventual fair value to accommodate the sentiment of the market place. Just as the line on the Superbowl will probably not be accurate as to the final score, it will bring in enough action on both sides to keep the casinos in business and allow them to fight another day. The only question is now, which side are you going to take?

John