Our resident guru explains the deal with short-term butterflies, hard-to-borrow stocks, and (ahem) “cleansing” techniques.
I bought a butterfly with just a few days to expiration, speculating that the stock would go to the middle strike, and it did. But the butterfly barely increased in value. What’s going on?
Think of butterflies as bets on a roulette table where there’s one “winning” butterfly at expiration. That butterfly is the one where the stock (the ball on the roulette table) lands on its middle—the short strike—at expiration. A butterfly’s value depends on the likelihood of the stock landing on the middle strike, making it the “winning” butterfly. The more time until expiration, the less certain where the stock price will land, and the lower the butterfly’s price. Close to expiration, there’s less uncertainty where the stock will land, and butterflies whose strikes are close to the stock price begin to have higher prices. It’s possible you just paid too much relative to its maximum payout value, due to buying too close to expiration.
On some stocks that are hard to borrow, I see out-of-the-money puts with really high prices. Why does that happen, and is there an arbitrage opportunity?
In order to short a stock (sell a stock that you don’t already own), you, or more specifically your brokerage and clearing firm, need to borrow it from someone that does own it. Sometimes there isn’t any stock in the market to borrow, so a stock becomes ”hard to borrow,” and therefore, you may or may not be able to short it. A trader that wants to short the stock and who can’t, might look to buy puts instead. That buying pressure on the puts drives their price up. But there isn’t any arbitrage opportunity. If you think puts are expensive the “arb” would be a reversal, selling the put, buying the call and shorting the stock. Uh-oh, you can ‘t short the stock either. You can do the first two legs of the arb, but not the third. So, no arb.
I’ve been learning more about pairs trades and have read about equalizing the notional value of the two underlying assets. What does that mean?
Notional value is the price times the dollar value of one point. For example, in the e-Mini NASDAQ future, /NQ one point equals $20. If the price of /NQ is 4,000, its notional value is $80,000. In the e-Mini S&P 500 future, / ES one point equals $50. If the price of /ES is 2,000, its notional value is $100,000. If you wanted a /ES vs. /NQ pairs trade, where the notional values were equivalent, you’d do 4 / ES futures for every 5 /NQ futures. The notional value of a stock position is simply $1, times the number of shares, times the stock price.
My nutritionist has suggested a cleanse, but I’m afraid I might become “indisposed,” if you get my drift, during the trading day. Any suggestions?
Cleanse? Kill two birds with one stone. Put on about 1,000 short gamma in expiring SPX options and don’t take your eyes off the screen until the settlement comes out. That should do the trick.
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Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
The risk of loss on a short sale is potentially unlimited since there is no limit to the price increase of a security. Equity pairs trading requires active monitoring and management and is not suitable for all investors.
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