Hello all, I am a student who is learning options trading in class and have a quick question why options trading is a zero supply market. I am studing the optimal decision selections for call options. In particular, I am looking at an example of an American call option's values with constant strike price K =101 and maturity date 2 on the coupon bond. If a trader exercises suboptimally where the payoff in the following period is lower, why does someone who shorted the call option gains? Can someone please explain in layperson's term? I thought about this many times, but I lack the financial knowledge or experience to understand how this works. Someone who fails to exercise optimally on long call option allows the other side (short call option) to earn the amount the longer missed? I even read a WSJ article that was published few weeks ago regarding how SCC is compelled to do something about this. Sophisticated traders are taking advantage of "normal" investors who exercise suboptimally in ex-dividend situation. I understand the benefits sophisticated investors reap from this situation is not huge, but I still want to understand the principle on which the phenomenon depends. Thank you!!!
It is because the person who exercices the option forfeits the time/volatility value of the option. Lets take a hugely simplified example with BAC: As I am writing this BAC trades at 14.23, the nov 13 calls are at 1.65$. So if average Joe buys the call at 1,65 and exercices it, he basically paid 14.65$ for a stock that is worth 14.23$. The Market maker who sold the call would buy the stock at market to hedge himself. He sells at 1.65 and buys at 14.23$ so his cost for BAC is 12.58$. If he is exercised at 13$, well he makes money. Granted this is a dumb example because no fool would actually do that (I hope!) but the principle stands, MM are hedged and will not be impacted by stock movement. They wish to capture volatility and if you exercise early, the option premium is forfeited by the option buyer. You see, that is the reason why most people do not understand the role of the MM. You are not playing against him when you are hoping for your stock to rise when you buy a call. In fact he is rooting for you, he wants the same as you, for your stock to go up because you will sell or exercise and he captures the premium. He can do this because he is delta hedged, what he prices in the options is volatility and not direction. That is why the say about MM that they do not have a view on a stock, only on vol.
Hold on, I don't quite understand... What does this have to do with zero supply? Moreover, maybe I am being really dumb. This is an American option and the underlying pays dividends? If that's true, there are actually cases where early exercise is optimal. It depends on the cost of carry and the dividend. Furthermore, you mention the ex-div period. Does early exercise occur during the ex-div period?
The only way for someone to take advantage of early exercise to capture dividend for "free" so to speak and take advantage of less sophisticated investors is to get into the pool of calls which should be properly early exercised and are not. That means they need to be short the call which should be exercised and is not. The only way to really do that risk free is to do ITM call spreads in strikes which a lot of open interest which should be exercised. You must also do those spreads at dead fair value and assume the costs associated with doing the spreads and exercising the long end of that spread. Your hope is that on the short side of the spread you donât get assigned on 100% of your short call side. In many cases there is a small number of investors for whatever reason donât or forget to exercise their long call on the dividend play. In order to do this you would really have to be a market maker and have fractional transaction costs and exercise costs. As someone mentioned this has nothing to do with the title of the thread and zero sum.
Read this first: If your question is a graded question at school, then you stop reading and consult with your teacher whether you should get help. Otherwise it might be plagiarism/dishonesty If I understand your question correctly here is the answer. The holder of the long call, could exercise his call to get the bond (which pays interest) and buy a put to protect the bond. With the put, one gets the same downside protection. The strike at which it is advantageous to do so is when the price of the put is less than the interest that the bond pays. So you save the the difference between carry and cost of put, which you do not if you keep the call. This happens only if the exercise is american, because the call cannot go below intrinsic (assuming negative carry).
Since the market is zero supply, some other investor is short the call option that you are long. He is long the underlying (stock or coupon bond) as a hedge against his short call position. If the optimal choice is for the holder (you) to exercise the call option, he is expecting his position (short call + long underlying) to get taken away just prior to the dividend or interest payment that caused the option to be an exercise candidate. If you fail to exercise, he gets to keep his position including the dividend or interest payment that you could have received instead, had you acted optimally. I did not read the WSJ article you are talking about, but I must say that "normal" investors DO exercise their calls optimally, for the most part. It is quite possible that a very small fraction of investors have no business trading options. But those people should not be referred to as "normal" at all, since they are very rare.
KPS thatâs the exact situation I discussed. The only difference is there are professionals who do the dividend capture spreads in huge volume so the odds of you being assigned and them moving into the counter party of those few options which are not exercised are greatly increased for those professionals. Donât forget assignment is random, so just because the part whom you sold your call does not exercise it does not guarantee you wonât be assigned. Anytime anyone who is long that call exercises it, if youâre short that call then you are at risk of assignment.