Let's say you have a small biotech company XYZ trading at $50, expecting to report pivotal phase III results in September. The one month out ATM puts are selling for $10 with 300% IV. Seeing vol is ridiculously large, an option writer opens a new contract speculating vol will fall even if a massive move occurs after trial results are announced. One month later, the trial fails, the stock plunges, and for the sake of argument, IVR turns out to be 110%. The option writer wins, right? Here is the problem: Almost all of the small cap biotech companies are one trick ponies with negative cash flow, no revenues, but worth hundreds of millions of dollars as trial success is already baked into the price. Through backtesting, company such as XYZ were worth close to $2 if their trial failed. Hence, even if IVR was 110%, the puts sold by the option writer are now deep, deep in the money for a $48 loss per $10 received in premium. Which brings back the question in the title. Who is the counterparty when one is buying these puts? Why would the option writer not account for directionality when demanding a premium?
Counterparty in the US is OCC. Who would sell them ? Outright speculators. Delta neutral traders hoping to capture volatility and remain neutral - probably means over hedging because it impossible to account for a gap down hedging with stock. Ratio traders and that would depend on the volatility across strikes and expirations - this is probably where a good part of the open interest - if there is any - comes from. Fundamental accounts that would acquire the stock at that net price. Keep in mind any of these "users" could be wrong and have a losing trade. My choice would be a ratio depending on the volatility across the strike and the liquidity. Is the stock "hard to borrow" - because then the implied is over stated - does mean it isn't huge.
No, the calls will trade under puts (vol) if the shares are HTB. It's as simple as pricing the synthetic.
It has nothing to do with implied - most models pick it up as implied, because you have a different carry for the call and the put. IN HTB you pay to short instead of receiving rebate. If you don't adjust your model and simply backsolve for implied without adjusting the carry the put implied is overstated. One easy way to get a sense of what you are paying to short stock is to solve the model with the same volatility and you'll observe the cost to short stock.
That's exactly what I am stating. Why would you solve using the same vol when the borrow is embedded in the discount on the synthetic?
ABC is HTB and it's running 8% per year to borrow. Rates at zero and no div. 1Y synthetic short is trading 8% under the natural. Duh.
Most of the borrow rate will be priced into the forward as the cost of carry, right? I mean, sometimes the carry is priced at two different levels because of the bid/offer (i.e. thus breaking put/call parity), but the volatility on the same price should be the same.
Exactly - but most misunderstand and model the put without taking that into consideration and then describe it as mispriced from a volatility standpoint.