Pricing leveraged-ETF options

[cttfs]

Looking at the options quotes of the leveraged-index-ETFs (e.g. TNA/TZA, TQQQ/SQQQ, UPRO/SPXU, etc), the bid/ask spread is often huge.

I'm trying to calculate where I could expect to get filled (without putting in test orders).
The mid-point is sometimes a good approximation, but often is not where the fills will happen.

1) I assume the market makers calculate where they are willing to trade the LETF options based on a function of the underlying index's option chain (e.g. RUT, NDX, SPX). Is that right?

2) If yes, could I take the index options myself and calculate where I could expect to get filled in the LETF?
The bid/ask of the indexes themselves are much tighter than the ETF, and its mid is more reliable.

I know this may not be trivial, but any pointers would be helpful. Thank you!

 

[sle]

Yes. The easiest approach is to simply multiply the implied variance by the leverage factor and use that in your model. There is also a matter of adjusting the forward since the borrow rates on these are HUGE.

 

[Reformed Trader]

Sle, I've been getting borrow rates for stocks using put-call parity, mostly because I don't know how to do it another way. Is there another way to get that information?

 

[Sig]

Sle, I've been getting borrow rates for stocks using put-call parity, mostly because I don't know how to do it another way. Is there another way to get that information?

A bit circular but it's implied in how much put-call parity is broken. Otherwise you can look at borrow rates at your broker, not ideal because they vary so much from day to day because the borrow market is so opaque and inefficient.

 

[Reformed Trader]

That's what I've found as well. If we have to derive the borrow rate from put-call parity but the spreads are very wide, how do we get a good idea of where the true mid should be?

 

[sle]

That's what I've found as well. If we have to derive the borrow rate from put-call parity but the spreads are very wide, how do we get a good idea of where the true mid should be?

It's tricky. If you are a market marker, there is a semi-liquid market for conversions in the OTC broker markets, but as a retail trader you're kinda on your own. In general, if you don't have divs, you can get it as a deviation from the implied forward on deep in the money strikes (most of bid/offer is vol bid offer, or at least that's the assumption). It's not perfect for various reasons - because long rebate and borrow costs could be somewhat different, because if it's really high there some probability of early X etc.

 

[Sig]

It's tricky. If you are a market marker, there is a semi-liquid market for conversions in the OTC broker markets, but as a retail trader you're kinda on your own. In general, if you don't have divs, you can get it as a deviation from the implied forward on deep in the money strikes (most of bid/offer is vol bid offer, or at least that's the assumption). It's not perfect for various reasons - because long rebate and borrow costs could be somewhat different, because if it's really high there some probability of early X etc.

While we're somewhat tangentially on the subject, the stock lending marketplace seems like a great opportunity to me from a business perspective. What are the structural reasons that there isn't a central, liquid, transparent marketplace for lending that's used by most of the market?

 

[newwurldmn]

While we're somewhat tangentially on the subject, the stock lending marketplace seems like a great opportunity to me from a business perspective. What are the structural reasons that there isn't a central, liquid, transparent marketplace for lending that's used by most of the market?

Many have tried to improve transparency in it, all have failed. To my knowledge, no bank consortium has attempted it (unlike other disruptive technologies like electronic ISDA's, dark pools, etc), so that's probably the answer.

 

[elt894]

While we're somewhat tangentially on the subject, the stock lending marketplace seems like a great opportunity to me from a business perspective. What are the structural reasons that there isn't a central, liquid, transparent marketplace for lending that's used by most of the market?

There's a lot of industry opposition that has shut down people who have tried: https://dealbreaker.com/2017/08/pen...chs-et-al-of-getting-just-a-little-too-tight/

For a while you could lend shares through AQS on IB, but I remember reading there was some rule pushed by industry players that effectively prohibited it. Single stock futures can mostly serve this purpose, but I think are only supported by IB and (at least for retail), and could be structured better.

 

[tommcginnis]

While we're somewhat tangentially on the subject, the stock lending marketplace seems like a great opportunity to me from a business perspective. What are the structural reasons that there isn't a central, liquid, transparent marketplace for lending that's used by most of the market?

In economic terms, "transaction costs."
All that paperwork (if digitized in 2018) that we sign in getting set-up with our brokers (whether introducing or DMA) includes an ability to make a stock-lending operation work, with little more than a check-box. Thus, we all hang out under the initial broker-client umbrella. To do this for individual transactions would involve a *blizzard* of new paperwork/record-keeping/liability/exposure, etc etc etc.

So, what's to stop some well-capitalized firm from setting up a separate, "Stock-Lending" window, where that special-purpose skill/market could garner repetitive business, making the thing worthwhile for customers and suppliers alike? "Hmmmmm!"

I'll bet you that the numbers have been run, and that they get revisited every 6 months or so... Like 'fracking' -- the technology is there, it's just a matter of deciding when the development costs have inched sufficiently below the potential revenues.....