breakeven

Moontower Munchies #95

Jan 22, 2025

Friends,

If you are into options and trading substance, you’re in for a treat. Ari Pine started a substack. Ari and I are friends from the floor. He's a big brain trader that also wouldn’t hesitate to grab a broker by the collar to get “recognition” in a fast market.

Ari was doing neural net stuff at CalTech in the 90s, got into option data analytics in the early 2000s, and was a floor trader for a long time specializing in gold vol. We met during that period of his career because we had the same backer.

[His twitter name, breakeven, is a reference to what we called a standard deviation on the floor. Breakeven is estimated by vol * spot price / 16 and it was an explicit column in our option software Whentech, now known as ICE Option Analytics or IOA. Many floor traders didn’t even set vols, they just toggled breakevens to match the market. Which is to say they had an almost pre-lingual appreciation for spot-vol correlation when you think about how that subtle difference reveals your thinking.]

In the late 2010s. Ari founded Digital Gamma a crypto custodian enabling tri-party lending. I joke that Ari has forgotten more about options and financial market stuff than most people will ever learn but it’s not a joke. He is well-versed on everything from repo, to gold leasing, floor trading, quant methods & implementation, and all things options.

The new Substack series is called Market Jiujitsu.

Prompting ChatGPT to combine Jiujitsu and the moon cause I’m corny like that

The first entry lays out the premise:

The title of this blog is “Market Jiujitsu” because my primary goal is to investigate and discuss how we can use the prices the market gives us — typically but not always derivatives markets — in way that suits our own situation or purpose.
The market can be a bit of a magician putting on an illusion and hiding what is really going on. Instead, if we can look past the surface, we may be able to see what is actually on offer specifically for you or for me in the wide availability of assets & prices. Just because Black-Scholes says that fair value for an option is X may still mean it is very tradable for us given our specific circumstance or market view.
The model and the standardized usage of options has become so fused to the prices themselves, that it becomes difficult to extract value out of the market that is not in line with these mental presets. The goal here is to give you some examples to escape and thereby take advantage of this very efficient market, and as a reach goal to help look at other parts of the world and see how best to unfuse bundled perceptions from reality and take “personal” advantage of the options market.
The topics that I aim to cover may be as specific as using the option market for taking advantage of the cost of hard to borrow stocks, lending or borrowing money via boxes, or mindset of a trader or some topics that I just find interesting and think you may, too.

The latest entry, Synthetics: Alternate Realities, absolutely delivers.

[It pairs perfectly with my recent over-the-shoulder livestream tutorial where I explain option cost of carry trades like reversals and conversion live. I swear we didn’t synchronize these lessons but we may as well have coordinated outfits.]

I’ll just excerpt heavily because I want to make how useful this blog is going to be obvious (all emphasis mine).

This post is about what I think is the most primary mental model for trading and particularly for derivatives trading: the synthetic position. I’m not going to go into much theory in this post and likely not too much if at all in others. This is meant to be a practical approach.

We can “replicate” or “synthesize” a call position by using puts and futures. We can take any of the two in order to make the third. This is what enables put-call parity. Which is another way of saying that if we know the prices of two of these building blocks, then we can figure out the price of the third. It also means that we can offset the original with the synthetic to create an arbitrage. We can 1) buy the call AND 2) sell the put and sell futures to create a conversion. Which, in theory, is now a risk-less position (it is not, but we are not there, yet).

We can go to Nvidia options to check out how market makers are setting “fair value” for the interest rate market makers plug into their option model. For 21-Feb-2025 138 strike: c = 6.6, p = 6.25, S = 137.71 (for trade date 1/17/2025; source Yahoo! finance). Plugging and chugging, we get r = 4.85%. That is a reasonable estimate of the “fair value” discount rate.

Why is the risk free rate in the options market not the risk free rate? Theory suggests that the observed discounting rate (the r in the Black-Scholes-Merton formula) should be something like the corresponding US Treasury’s market yield, e.g., 3-month T-bills. It is not because aggregated market participants don’t get funded at the same rate as the US government. Let’s take a step back for a moment. Suppose that a market maker thought that the rate should be 4.25%. That would drop the price of calls, raise the price of puts (dropping calls by 4c and raising puts by 4c). The market maker would be consistently selling calls, buying puts, and to hedge that, buying NVDA stock. The NVDA stock has to be paid for and market makers have to borrow the money to pay for it. If that rate is 4.25% or less, then our market maker friend is fine. If the rate turns out to be 5.00%, the market maker will lose 75bps until he adjust his rate to a level that balances out his stock purchases and sales. Right now, that level is 4.85%. Tomorrow it may be 4.5% and next week 5% (this is called “rho” risk).

Similarly, had the market maker set rate parameters too high, e.g., 5%, and thereby made the operation the best bid for calls, best offer for puts. That would result in purchasing calls, selling puts, and hedging by selling stock. Selling stock raises money in the trading account. If the account earns only 4.5%, then there would be a 50bps loss in the account over the course of time.

Great. Where am I going with this? 4.85% might be fair value to the market maker in order to balance lending and borrowing for their firm. YOU can take advantage of that. Originally, when I wrote about the call being 6.6 and the put 6.25, that is not exactly true. That was the mid-market pricing. The call market was 6.55-6.65 and the put market was 6.2-6.3. That means that the NVDA 21-Feb-2025 market on lending & borrowing USD was 4.1% - 5.61%.

So how is this helpful?

Goal is to get long NVDA stock and there is no readily available cash. Your broker’s margin rate is 11% to borrow USD to buy the stock. Instead, you buy call, sell put to purchase the synthetic stock position paying 5.61% financing.
Goal is to purchase an NVDA call, you have excess cash in your portfolio. Your broker’s sweep account pays 2%. NOTE: this is not really the case right now but during the era of 0% Fed target rate, this was pretty normal. Plugging in your rate of return (2%) values the call 6.41 and put 6.44 — in this case making the purchase of the put with stock the better value specific to YOU.
You are limited in short term investments. Perhaps your brokerage sweep account only earns 2%. Then you could sell call, buy put, and buy stock to earn 4.1%.

So far there are 3 posts in three weeks so my expectations for cadence are high. I have zero doubt the quality will be high. No pressure Ari, but also yes pressure. Selfish motivation to read your mind split open.

In the one other post he’s published. You Don't Use Your Instagram Self to Trade, Ari does a version of over-the-shoulder education where he walks thru what seems like an an annoying rounding error but actually pointed to a subtle misunderstanding about how cost-of-carry is calculated. He uses a common shortcut but when it comes to code sometimes you forget what’s a shortcut and what the true mechanics are. The post is a reminder that finance, in all its pennies, requires attention to detail.

Ok, I’ve made my points — we can all learn a lot from Ari.

More Ari efforts:

🔗An old but goated Medium post: Everything You Thought You Knew About Spoofing is Wrong! (8 min read)

🎙️Scientific trading, and process over outcome (Chat with Traders podcast)

As an fyi, I immediately added his substack to the moontower collection of blogs and newsletters. I’m most qualified on option crap so those letters are the ones you can be most confident that the recommendation is solid although I do browse the work of everyone I put in that resource or at the very least they are rec’d by someone I trust.

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