Acting as Virtual Marketmaker on options market

Discussion in 'Options' started by cowmoo, Sep 11, 2010.

  1. cowmoo


    Hi guys,

    I recently noticed a really strange put-call parity on a volatile pharmaceutical (ARNA crashed right before close, someone had probably GTC ITM call that reflected the pricing of ARNA before it crashed but forgot to cancel it when ARNA went down) that last for a couple of minutes, where one would have made big money if he/she traded the box spread on it.

    This led me to look into box spread arbitrage; now, earlier threads here and other various sources such as Wikipedia all claim that box spread arbitrage opportunities are slim, profits are negligible (eaten up by transaction costs).

    But when you look at almost any liquid stock's option chain,

    if I could execute my short call's and put's at the maximum of the last trade and the half-way past the mid-point bid/ask (say the bid/ask if 5.10 and 5.25, I improve the asking price by moving it to 5.22);

    and if I could execute my long call's and put's at the minimum of the last trade and the half-way past the mid-point bid/ask.

    Almost in all cases, you net a profit of $10-30/contract (see GOOG September box spread at 260-270; if you 260 short call's, 270 long call's, 270 short put's, 260 long put's were executed at the price respectively of 5.22, 0.84, 7.57, 1.80); same example is reflected in the case of ARNA September box spread at 7-8.

    Now, taking into consideration of transaction costs, IB charges $0.75/contract, or $3.75/contract so if I could make an average profit at around $15/profit, then TC is not an issue. Also for margin requirements, I calculated it roughly for you profit to be a return of 1% to 3% of your collateral (e.g., to make $150, you will need to put down $10,150 on 1.4% return).

    This doesn't seem very much return, but if you do this type of box trading right before option expiration, then you only need to hold onto your box for a couple of days for the return. Now, with CBOE introducing weeklies, you could potentially do this on a weekly basis.

    But there's still some risks such as assignment risk, but my thinking is if I don't trade options with underlying equity that pays out dividend; even if I get assigned (let's say stock goes up and my ITM calls gets assigned), my counter-option position, my other long call and short put would also moved to would balance my P/L out.

    Finally, there's execution risk. Market makers can do this day in and day out because they have low transaction cost and could modify/cancel their quotes the fastest. How can I get my orders executed in front of the market maker?

    My thinking here is that I'll use IB's combo trader to submbit a multi-leg order to the market. To be honest, I'm not sure how IB's smart-router is going to execute this type of order but as I understand it: on ISE, it perform some kind of multi-leg matching and on other options exchange, if my orders hit the market bid or ask, it gets executed; otherwise, it remains a hidden order until someone else improves the price in my favor and IB will execute that leg for me. However, the multi-leg order has to have the same number of its legs executed, ensuring my box spread.

    I will have a option quote stream running throughout the day and pragmatically modify/cancel the pricing my combo order (to the pricing model I described above) as the option pricing bid/ask changes. On IB's fees/commissions page, it states that cancel/modify fees are not applied to combo orders (I'm not sure if this is also the case with pass-through exchange cancel/modify fees). So assuming that this is true, I could modify/cancel all day long with out penalty like a market-maker, until I get my box spread order filled.

    This is my thinking. I apologize for the long post, but I wanted people to poke holes in my strategy as the saying goes, "if it's too good to be true, it probably is."
  2. I'm not knowledgeable enough to tell you if this strategy is viable or not, however on the surface it seems difficult given how traditionally box spreads at the retail level are effectively pointless when one factors in transaction costs (though I did read how you purportedly seem to overcome such issues). Moreover, I must ask you is it worth ALL that effort to make such a significant investment all for a whopping 1.4% ROI? You seem well versed in options so I wonder if you aren't better off directing your energies elsewhere for a better risk/reward/effort?

    Not to nitpick but I certainly don't see GOOG 260/270 Calls/Puts trading at the prices you quoted. I assumed it was a typo so I went to the 460/470 calls/puts (ATM) but no such luck on those strikes either. If you could re-illustrate the example with the strikes you actually intended that would be really helpful :)
  3. This is most likely a threshold "hard to borrow security. So in effect the american box sells for more than it should because the risk in the box is that the early exercise will create a short in the stock that can't be found.
    The call gets exercised. A short is created. A borrow needs to be found. If you simply rehedge - commonly via a buywrite - you violate reg sho.
    You may find your broker may prohibit the trade or at least make you agree to pay the fine.
  4. cowmoo



    Sorry I lied about the option prices for GOOG; what I meant was the option price for AAPL, I quoted the last traded price for 260, 270 call's and put's.

    Tally them together (sell the higher priced calls and puts and buy the low priced calls and puts) and it should yield about a net profit.
  5. ITM money options rarely trade. Look at the daily volume. You will simply not get a fill on these options. Also, there is pretty much zero chance that you can get filled on the box all at once, either through working a complex order, or through working single legs. Therefore, you would have no choice but to hedge your trades, and work into the box one by one. This would result in massive slippage, as well as extra margin costs until you could box off your risks. Since you would probably not be able to trade most ITM options, your option risk would be open for a while--opening you up to losses.

    MM's have faster connections to the marketplace, giving them an advantage in this arena. Though, I can tell you from years of market making experience, that boxing off risk is extremely difficult, and rarely works in practice.

    Having said that, a retail customer would have a liquidity advantage, since a retail customer order goes to the front of the que AHEAD of market maker and professional customers. So, if you really want to try this here's what I would do:

    Notice that an AAPL ITM option market will be MUCH wider than the 1 to 2 penny wide OTM market. Send a complex order to the CBOE or ISE to either buy the ITM P or sell the ITM C first, combined with enough stock to be delta neutral. Work your order a penny or two in front of the disseminated market, and pray that you get filled. If you do get a fill, instantly cover your option risk by trading the OTM option pair against your opening trade, then hope you can get a fill on your extra stock to be left with a synthetic stock vs actual cash stock position. Then do the same for the other side of the box by working a complex ITM options vs stock order, pray you get a fill, and instantly leg into a cover in the more liquid OTM option and stock.

    If you stare at your working orders for three days, and everything goes flawlessly, you might be able to work into a few boxes here and there for a nickel or two after costs.

    I think you will find that the opportunity isn't worth your effforts.

    If you are a huge customer trading operation (like Simplex, for instance) you could invest in the fastest lines in the world (around a $400k per month) and negotiate to have PFOF fees passed through to you, convince a broker to let you have naked sponsored access, and create all your own modeling, logic, might be able to make strategies like this work.

    In you situation, I think it might be a useful educational experience, and will result in net losses rather than any profits--but, alas, this is how all of us learn.
  6. cowmoo



    Thank you sir for such a detailed & helpful reply.

    I went back to my options P&L tool and replicated the legging into a box steps while remaining delta-neutral with covered stock that you detailed.

    An interesting thing I noticed is that, by just doing the first part of the exercise you described (e.g., buying and selling an OTM call/put pair and hedging with corresponding amount of underlying stock), even executing at the market price, you can make a profit.

    e.g., look at ARNA

    Sell a call on 9/16 $8 @ 2.35 (bidding price)
    Buy a put on 9/16 $8 @ 1.35 (asking price)
    Short 100 share of ARNA @ 7.01 (last traded price)

    Add it all up, you make $11 in all expiration date scenario's. At IB transaction cost (0.75*2+1 =2.5), you still net $8.5/contract on a collateral of $811, return of 1% (holding onto these contracts and shares until expiration date in a week). Obviously, if you get your orders filled at much better market price, then you stand to gain even more.

    You are right that executing all four legs of the box at the price I named in my favor probably won't get executed all at once, but I'm thinking if I just try to get a two-leg order filled with prices slightly favoring me (le'ts say, I sell the call at a price of $2.37, improving the ask significantly from $2.45, and buy the put @ $1.33, improving significantly the bid from $1.30, and I can buy 100 shares of ARNA at $7.00 in a slippage advantageous to me), then I stand to gain more with better probability that my order gets filled.

    Please poke holes in my idea and thank you for your feedback, it's very generous of you teaching your trading experiences to others.
  7. rew


    In my experience IB's ability to execute combo trades is pretty poor. I can usually get a better price by buying/selling the option legs separately. This is without day trading, just buying a call and then immediately selling another call (without the underlying changing in any significant way) gets me a better price than waiting for IB to execute on a vertical spread. So I suspect you'll have poor results waiting for IB to buy you a box at the price you need.