99% likelihood that it was a large buy-side (hedge fund). And selling an upside call in VIX runs a bit more than $100. Let me guess; you watched WSW?
Market makers don't take huge directional bets (1987 was such a downer for them) so IMO, it is mostly likely that this trade was offset (in 100s of ways) relatively quickly. If one trader sells an option to a second trader and both hold until expiration how can they both make money? If you mean that volatility could spike then someone else stepped in to take the net plus the profit. So doesn't someone ultimately win and someone lose? Nitpicking whether it is the original two traders is missing the point isn't it? Am I missing something? Could you explain your comment above further?
The market maker that took the other side delta hedged and the realized vol of vix was so high that he still made money
I was asked this question by a fund manager many years ago who used to sell me options, I bought them - we both made money. Back in the 1990s.....I used to tell him, dont worry about it, dont think too hard on it, just keep selling them we will all be happy. --- maybe Trading journals is that fund manager. as Jgills says.... Easy answer - I traded the gamma - bought and sold the underlying, spread against other options. Most likely I broke even or made a small amount unless the actual/realised/historical volatility was high. He did one trade, I did many. These days you might spread against many instruments. Point is that in reality it is not a closed example as many theoretically like to describe it and it helps to think about it as more than an individual trade in isolation.
With due respect to Jgills, his answer seems to indicate a lack of understanding of the options game that is very common on this particular board. He used a portfolio term for market making. I stand by my comment above. But why quibble, some of these guys send me money from time to time. If your desire was to be a top notch surgeon, would you prefer to learn from someone who has written lots of industry accepted books on the subject or someone who does surgery every day and/or is known for surgury? My advice is similar - learn option trading from traders, not mutual funds or university professors or models. They can only take one so far. I agree with your last comment when actually trading, however, while waiting for certain things to happen in the market, I do from time to time, think about theoretical questions that have important implications to edges and trading principles. Most time they are just fluff, but only one or two in 20 may result in brilliant insights and methods to test. Since any single trade can result in a win or loss, no matter whether the trader was right or wrong ultimately ( timing and news play a part too) it follows that basing anything about the market based on a single anything is (IMO) a foolish thing to do. One secret of the market is that most of the trading skill that is freely available doesn't really work and that is why it is out there to be had (or maybe traders are out there to be had?). Put another way, the market is efficient at discounting the truth. The market doesn't care if the trader knows the truth. I have found SLE to be highly intelligent, so I take his comment above to be just an big picture answer to stimulate thinking.
Path-dependency. Zero-sum only applies to the single-option in isolation. It's not a practical concern. I can short XYZ and sell two ATM puts and buy wings... see the shares rally and actually gain on the drop in vola. The parts are zero-sum, but not the whole.
to me JGills made perfect sense.....what do you mean he used a 'portfolio term'? (an academic term maybe?) If your comment was "how do both make money" from sle then you basically answered yourself before you asked the question...(or was it not really a question?)......JGills confirmed his version, and I did much the same....and added the story of a fund manager asking a similar question many years ago.....these were real trades, not theoretical ones. I think a lot gets lost in terminology when we are all speaking Chinese but hearing Spanish. From my own experiences of equity option market making 1992-2004 and purely directional trading 1998-present, most trading skill is in waiting and doing little while most market making skill is in collecting an edge and managing extremes but also doing as many trades with edge as possible. (these days its probably changed with HFT). There is still skill in market making. There are still plenty of ways to give up the edge or think the model is never wrong. But its pretty much as simple as that. The truth - luv that term - is what ever works in reality, and if its discounted then its probably because its a diamond in the rough, as the best things in life are free! I guess for me it boils down to dealing with how things work in reality, and not worrying too much about the theory v the reality, BUT still understanding the risks - you probably shouldnt just sweep those under the rug. ....and yes its all interesting for discussion.
I was not sure of the word Delta Hedging vs Offset. They are different concepts. Strictly speaking both comments were correct, just that I was describing something else. No slight was meant to the comments, just clarification of terms that I thought I might understand ( but maybe I don't). To make you feel better, I am earning money today ( options expiry) but in one position, I need to watch a bit more closely due to some odd behavior. So my comments are based on tens of thousands of live trades and multiple methodologies. That BTW, doesn't mean I am always right or perhaps even listening in a different language as you correctly point out. I was wondering if there was something about SLE's comment, I had wrong, but perhaps not. It was simply a chance to learn for me. You make great comments. For me, truth and reality are actually pretty much unrelated, but it has become popular to believe that perception is reality so I am from the old school where truth was reality. LOL. I am enjoying this thread immensely but have to see what the movers and shakers are doing in one option position I am short in. Talk again next week.
I agree with your comment and disagree with the "it is not a practical concern". I think it can become one. Understanding in most thing in life IMO is about exceptions and exceptions to the exceptions and .....
In this particular case, one trader sold a naked 22-strike call to a market maker, who hedged delta in vix futures. If the market-maker continued delta-hedging on daily basis, he would have locked-in higher realized volatility then the implied he paid to the original trader. From the sellers perspective, this was a bet on the distribution of the outcomes (22 is not going to happen) and was rewarded well for the risk. From the market makers perspective, this was a bet on the difference between realized and implied volatility of the February futures. Lets assume, for simplicity, that the MM simply held on to the original delta - the trade was done on Feb 5th ref 19.2 with .35 delta @ 1.1 (I think, not sure if the numbers are right). The futures price on Tue (when any sane person would get out) was 14.25, so MMs hedge P&L would have been -0.35 * (14.25 - 19.2) = 1.73 against the premium of 1.1. The market maker made .63 on the trade. If he delta hedged at the TAS daily, he roughly broke even (made .012) accodrding to my system. The overall idea is that an options trade against a market maker is not a closed system, since the MM will delta hedge. It is very fasible that both traders will make money and just as possible that both traders will lose money.