Susquehanna is one of the big firms doing this and the founder is a Market Wizard so I'm pretty sure he's making a nice profit. They are probably using dynamic hedging strategies to offset risk aim for a small profit. http://www.susq.com/
Since bullets are usually one day creatures, are you really long a put? That is, does this transaction really involve actual exchange traded options (i.e., do you actually have 10000 shares long of XYZ and 100 XYZ puts long) - or is this just a firm-level bookkeeping transaction where they're providing a hypothetical over the counter put for a small fee because they've neutralized their overall exposure at the firm level and have no risk? Something like - you want a bullet for 10,000 shares of XYZ. So they establish an open short for 10,000 shares of XYZ in a firm-level wash account and then buy your account in for 10,000 shares long at the same price and then "sell" you a hypothetical over the counter put (with a delta=1.0). If price goes up all day and you just sit on the position, you're closed out flat at the end of the day and they use your long to wash their short - firm has no net risk. If you sell your long (to become "short"), the firm is net short but you're at risk for it, so firm still has no net risk. At the end of the day, after everything's netted - firm had no exposure and whatever profit/loss there was hits your account. Traders would naturally perceive this as long stock/long DITM put even though this kind of implementation didn't really involve exchange traded options - perhaps Don or someone could briefly discuss the specific mechanics involved at their firm.
I don't think they are exchange traded options. They print the stock at a regional and then create an option OTC.
The option is an OTC option. They invent it and it gets exercised at the end of one day. As one securities lawyer (formerly with SEC Enforcement) told me: "A bullet is a fiction, a non sequiter. It's an economic toll booth," to get around the uptick rule.
I have always been under the impression that Bullets and Conversions are different animals. Bullets are 1 day tools and Conversions are for much longer time frames (depend on expiry of underlying options used). As I have never been responsible for constructing either, I do not know the difference as to how they are created. Can some one enlighten me here? I know this topic has been beaten to death and then some, but it always seems to elicit responses whenever it is brought up so what the hell. I have used these tools in the past as a prop. but was never told anything about them. Just requested the stock ( or stocks, never more than 2) that I wished to have a "bullet" for and I was able to short that stock on a downtick for the entire month. The props. always had to state which stocks they wanted for the month a couple of days prior to the beginning of each month and that was the extent of the trader's involvement in the process. But ever the curious one I have always wished more knowledge on this subject. Thanks to the wise and enlightened among us! MACD
Bullet= Long stock, long in-the-money put Conversion= Long stock , long put, short call (the combined position of the long put and short call at the same strike is known as "synthetic short stock" since it's P&L is equivalent to being short the stock). Thus you are long the stock, and synthetically short the stock, for a perfect hedge! Bullets generally are for 1 day. Look at the book "Options As a Strategic Investment" to see the graph of why this is a hedge if the above doesn't make sense.
Thetraderprofit- I have always suspected the same thing. An otc option made within the company which gets exercised at the end of the day? The ecomist in me says hey there is no free lunch but how do we say Mariginal this equals marginal in this transaction. Now I would really like to know what actually happens and if susq experiences any risk at all on any part of the transaction at any time. In fact do they do anything besides confirming the bullet. Also why is the urban legend around that if the stock were to really move the bullet buyer makes money. How is that happening. What is to stop me from opening JEM bullet factory and charging less than everyone else. One part of me says there must be something to stop me from doing this and there must be some risk involved to the bullet granter but I can not see what is preventing them for just saying hey the bullet is yours. Are they really lending me stock or just telling me to go for it. If anyone really knows I would love the info.
jem - The "OTC option" has to be notional. For the firm to have zero risk, they would have had to do something like I suggested earlier, i.e., setup a short in a firm level account against the long position in the trader account. So you're account is long the stock, but with the firm account short - the firm overall is net flat. The "OTC option" is virtual and primarily a bookkeeping treatment used to net/wash/reconcile at the end of the day. That could only work at a firm level for that firm's accounts (which are actually sub-accounts of the firm's overall account) - so you can't personally go into the "bullet factory" business.