The Art of Streetplay

Thursday, July 14, 2005

Market Dynamics

Question: What does the issuance of put options to the open market do to the dynamic of the overall marketplace?
Hypothesis: The issuance of puts (1) exerts a stabilizing, mean reverting dynamic on the stock process, and (2) decreases the market implied volatility.
Basis Behind (1): all else equal, the market has bought and absorbed the put options. This decreases the market delta, and increases market gamma, and vega, all else equal. Why? Because the general public is buying from the company and not from other investors. If the company were buying from other investors, the net effect would theoretically be zero. However the general market is buying from the company, bringing those options into existence for the first time. Furthermore it is easy enough to track whether or not the put issuance has been hedged-- without loss of generality we can assume that it is not (or else we would simply retract all hypotheses). Finally assuming that the market absorbed the options with no problems, while it is theoretically possible that they fully hedged their position by longing the underlying, this is highly unlikely. The residual market delta is most likely to be negative.
So now let's think about what happens when the stock goes up. If the stock goes up, the puts get more out of the money, and the delta, which was negative, becomes less so. Assuming that at least some of these investors track their market exposure, some of the bigger investors will see this happen and attempt to re-establish their market exposure. They would do so by shorting off the delta increase. If the market goes down, they would conversely long off their delta decrease. Thus, the market stabilizes.
Basis Behind (2): Let us assume the issuer of the options is MSFT. MSFT has sold put options, so it's vega is negative. The market has bough the put options, so their vega is positive. We know MSFT won't hedge its vega. It should also be a reasonable assumption that the market will not hedge its vega either. We need to look at this from a supply/demand point of view. The supply of options has increased, while the demand can be assumed to be fairly constant- MSFT was the issuer after all. Supply and demand would imply that IV would have to go down as a result.
Also, we can think of MSFT as the initiator of the transaction in this case. The market in this case is nothing more than a counterparty. If that's the case, then even if you make the argument that on a net-net basis the change in vol should be zero (because you have a buyer and a seller at the same time), the fact that it was MSFT who initiated the trade indicates something.
Structured Products, I believe, are part of the reason why implied volatility is down so markedly.


Post a Comment

<< Home