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Ask Trader Guy: Inflated Index Options? Not What You Think

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October 15, 2014

Q: Why is there a cost to carry built into cash index options when you can’t actually buy the index?

T: Options on things that are cash-settled—like SPX, NDX, DJX, for example—don’t deliver stock at expiration, but still have a cost-to-carry component built into their prices. The reason is that you can actually go out and buy the stocks that comprise the SPX and use them as a hedge for a short SPX call. You’d need a lot of money to do it, but it’s possible. And if the SPX options didn’t include the cost of carrying a portfolio of the underlying 500 stocks, then the institutions that do have the money to buy the SPX portfolio would have risk-free profits.

Q: I’ve heard of other greeks like vomma and vanna. Are they useful?

T: Option greeks are derivatives of the option pricing formulas themselves, like Black Scholes. And if you have a head for calculus, you can take the 2nd and 3rd derivatives of the formulas and come up with some interesting-sounding metrics. Vomma, for example, is how much vega changes when volatility changes. Vanna is how much delta changes when volatility changes. But most traders never look at the higher-order greeks because there’s only so much you can do with them. If you’re an institution with a huge options portfolio, then maybe for example these higher greeks can show you how to reduce your market exposure if volatility rises. But to most traders, standard greeks offer enough information to manage positions. Understanding how changes in the stock, vol, and time impact on P/L become more important than the impact on individual greeks.

Q: So you’re going to a desert island for a year and you can only take a case of Sriracha or Cholula. Which do you choose?

T: Wow, tough call. Sriracha is more viscous with a peppery, vegetable heat. Cholula is a bit saltier with more piquancy than heat. Both are supremely versatile. You have to think regionally. If the desert island is Tahiti, I’m going with Sriracha. Isla Mujeres, Cholula.

Q: How come at-the-money LEAPS options have a delta higher than .50?

T: If you look at stock options across expirations, you might notice that the delta of the at-the-money option may be less than .50 in near-term expirations, and over .50 in LEAPS options with further expirations. Volatility and the cost to carry impact the delta, but the main reason at-the-money LEAPS have deltas higher than .50 is the log-normal distribution of stock prices. For a stock, the lognormal distribution is bounded by $0 on the left-hand side, and infinitely high on the right-hand side. That’s because stocks can’t go below $0, but could go infinitely higher. Because there is a slightly higher probability of higher stock prices over time, and that fact is more pronounced the further out you look, the delta of those further-expiration options can be slightly higher than options in nearer expirations.

Q: After I heard AAPL* bought Beats by Dre, I bought a pair of Solo2 headphones to support the company. But I’m 85 years old and the bass makes my artificial hip rattle. Should I bring this up at the next shareholders’ meeting?

T: I’m not sure if the AAPL board is qualified to offer medical advice. For a quicker solution, add olive oil and deep fried foods to your diet for extra lubrication.

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