Cash settled options on US equities

[ajacobson]

Market Makers are not the only market participants and it shouldn't be only about making their trading lives easier. Lot's of customers would benefit from having the ability to not deal with physical settlement. We redid symbology and it would certainly be possible today to do a pilot on a handful of high dividend names that are broadly held. I hate to draw the analogy of the jumbo spyder where "the exchange community didn't want it - with the exception of BOX - so the exchange community became and obstacle and it is virtually dead. If a couple exchanges had listed it and it became linkage eligible I would bet it would have developed scale.
How many small retail customers and small institutions really understand the economics and dynamics of early exercise and MM who can trade under fee caps. The customer is a distinct disadvantage. Third Friday trading and Physical settlement are legacy issues we need to change. We have been moving away from third Friday and we should move away from physical settlement

 

[Sig]

Yup,as well as simple hassle of getting out of delta at expiration. In the OTC world, MM would still insist on physical settle or on some sort averaging.

If you don't mind indulging a couple of ignorant questions; I get the market manipulation piece but don't understand the delta piece. Wouldn't MMs in existing cash settled index products like SPX (thrice) weeklies face the same issues or is there something different about indexes that I'm missing? Also a related question not having ever been a professional MM, how much delta hedging in the underlying is actually happening? I guess I always kind of assumed that it was a kind of a last resort thing if you had to lay off a big order or a wave of trades in one direction but that you mostly tried to just do the bookie thing and balance the book as best you could, but I may be way off on that assumption? Thanks.

 

[haroldg]

Cash settlement is a solution in search of a problem. If you can't deal with deliveries, you're undercapitalized. It's G-d's way of telling you not to trade options.

 

[Sig]

Cash settlement is a solution in search of a problem. If you can't deal with deliveries, you're undercapitalized. It's G-d's way of telling you not to trade options.

With all due respect that's complete BS. There are plenty of strategies that trade narrow vertical spreads where the total risk is something like 5% of the cost of taking delivery. In other words, you have to keep $95 in cash in your account to cover $5 of exposure. Certainly you wouldn't rationally argue that putting more than 5% of your equity at risk is undercapitalized, would you? And that's just one example, pretty much any spread strategy requires multiples more capital just to cover the potential delivery cost and would benefit from cash settled options.

 

[sle]

If you don't mind indulging a couple of ignorant questions

I never mind and asking questions is never a bad thing.

Wouldn't MMs in existing cash settled index products like SPX (thrice) weeklies face the same issues or is there something different about indexes that I'm missing?

If you have a meaningful position expiring in the index space, you usually try to trade combos that have the same expiration. Eventually it all flows into a cash expiration of futures, so you are not really carrying any delta execution risk. Without a liquid cash-settled delta-one market, managing your delta is a PIA of epic proportions since you have to somehow match the execution of the delta to the settlement price.

Also a related question not having ever been a professional MM, how much delta hedging in the underlying is actually happening? I guess I always kind of assumed that it was a kind of a last resort thing if you had to lay off a big order or a wave of trades in one direction but that you mostly tried to just do the bookie thing and balance the book as best you could, but I may be way off on that assumption? Thanks.

There is certainly a lot of delta hedging going on. As a market maker, you are not really trading "options", you are trading risk factors, while locking in a vig. For example, you might buy gamma in one strike, hedge delta and then have an axe to sell gamma in that name, which you would (hopefully) eventually get filled on. So you'd never really get a clean book, but rather your book is flat delta and flattish primary vol risks. However, as the underlying moves and time passes, the delta will change and you will have to re-balance delta. Also, some MMs will accumulate large positions that that can't (or don't want) to lay off and have to delta hedge a lot.

 

[sle]

Cash settlement is a solution in search of a problem. If you can't deal with deliveries, you're undercapitalized. It's G-d's way of telling you not to trade options.

I disagree. A lot of HF clients, for example, want to have cash settled options because they don't want to deal with the ensuing cash position.

 

[haroldg]

don't want to deal with the ensuing

Markets exist for the benefits of hedgers / real-money players, and are arranged for their convenience. Speculators just come along for the ride. Puts and calls have been stock-settled for 100 years, because that's their purpose, to enable hedgers to put stock to you, or call stock from you, as their hedging needs require.

The downside to cash-settlement, especially in less-liquid underlying names, is manipulation. If you don't understand how / why, ask an experienced trader to explain it to you. If this risk is weighed against the reward of enhanced convenience for undercapitalized speculators, I know how I'd choose.

 

[Sig]

Markets exist for the benefits of hedgers / real-money players, and are arranged for their convenience. Speculators just come along for the ride. Puts and calls have been stock-settled for 100 years, because that's their purpose, to enable hedgers to put stock to you, or call stock from you, as their hedging needs require.

The downside to cash-settlement, especially in less-liquid underlying names, is manipulation. If you don't understand how / why, ask an experienced trader to explain it to you. If this risk is weighed against the reward of enhanced convenience for undercapitalized speculators, I know how I'd choose.

I'm pretty sure sle understands the risks of manipulation. Did you ignore my very detailed response with examples of how you could be risking only 5% of your capital and still not be able to take delivery if you're trading spreads. Again I ask you, how can you possibly consider putting 5% of your capital at risk undercapitalized? And what kind of BS is this that somehow only hedging an actual stock position is a legitimate use of the market? Says who, you? Guess what, the world isn't black and white and there's a lot that all of us don't know we don't know. I can give you a number of examples of non-speculative uses for cash settled options, not that speculative uses aren't just as legitimate, but that would be awfully inconvenient for you and you'd probably just ignore that as well. And while you're at it insult the guy (sle) who's clearly worked for years in the market and provides significant value here with his experience by telling him "ask an experienced trader to explain" manipulation to him. You're a piece of work.

 

[Maverick74]

I'm pretty sure sle understands the risks of manipulation. Did you ignore my very detailed response with examples of how you could be risking only 5% of your capital and still not be able to take delivery if you're trading spreads. Again I ask you, how can you possibly consider putting 5% of your capital at risk undercapitalized? And what kind of BS is this that somehow only hedging an actual stock position is a legitimate use of the market? Says who, you? Guess what, the world isn't black and white and there's a lot that all of us don't know we don't know. I can give you a number of examples of non-speculative uses for cash settled options, not that speculative uses aren't just as legitimate, but that would be awfully inconvenient for you and you'd probably just ignore that as well. And while you're at it insult the guy (sle) who's clearly worked for years in the market and provides significant value here with his experience by telling him "ask an experienced trader to explain" manipulation to him. You're a piece of work.

His theory is correct and so is your point about verticals. They are not mutually exclusive. There is a lot of economic theory that goes into hedging and it's been written about extensively. Ultimately to drive liquidity, you have to service the true hedger, not the speculator.

 

[Sig]

His theory is correct and so is your point about verticals. They are not mutually exclusive. There is a lot of economic theory that goes into hedging and it's been written about extensively. Ultimately to drive liquidity, you have to service the true hedger, not the speculator.

I'm the first to agree that you could be over-leveraged if you can't take delivery of options, but there are a number of scenarios where you aren't over-leveraged by any stretch of the imagination. This haroldg character is certain that only his version of the world is true, you must be over-leveraged if you can't take delivery. He's the one claiming we're mutually exclusive, I'm arguing exactly the opposite!
Smart well meaning people can disagree forever on the role of speculators versus "true hedgers" in the market. However even if you buy the idea that markets are only for "true hedgers", the concept that you can't have a cash settled product in such a market is asinine, that pretty much rules out the entire cash settled futures industry as "without purpose" according to haroldg's view of the world.