Here's How Derivatives Traders Take Money from Credit and Equity Traders

“I lost a couple million last week, probably lose a couple million this week.? As long as I can afford to pay my wife’s tennis instructor it’s fine.”

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It was early September 2008 and I had moved from Chicago to join Lehman Brothers at the beginning of the year.? The guaranteed comp on my contract moved the needle for me and I could see it was in jeopardy.? I looked to my MD for any sort of assurance and his response was a masterclass in stress management.? Then again, what else would you expect from a former undercover FBI agent who now ran derivatives trading at one of the biggest desks on the street??

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Of course we weren’t the only bank having problems.? There was always an assumption that “too big to fail” was real and bailouts would be obligatory.? That sentiment was quickly sobered up with a simple phrase – “Even Rome fell”.? If you were exposed, it was time to hedge or die.?

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One of my bigger surprises on Wall Street has been how little people know outside of their specialization.? Credit guys will spend an entire career focusing on the left-hand tail risk (downside) whereas equity guys focus on the right (upside).? Rarely do their interests intersect, but 2008 marked such an occasion.? Scrambling to hedge their books, opportunities for capital structure arbitrage were plentiful.?

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In cap structure arb, the trader ventures outside the comfort of their own asset class to hedge their risks in another.

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The catastrophe scenario for a long bond holder is the company goes bankrupt and the bond is worthless.? A bond trading at 95 cents on the dollar can go to 15 cents on the dollar very quickly in this scenario.? If this were to happen, it is widely expected that the equity value of the company would go to zero*.?

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*nb: Bankrupt companies rarely trade at zero.? By purchasing the equity I am entitled to my share of the NOLs [net operating losses] that I can use to write off against gains.? This is why you saw Lehman stock trade greater than zero after the bankruptcy.

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Since “zeroing” the equity is a prerequisite for major bond losses, credit traders will often sell some stock against their bond as a hedge.? The problem here is stock could go to infinity.? If that happens, the losses on the stock will outweigh gains on the bond yield.? To solve this problem, sharper traders will purchase a put against their bond.?

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The logic here:

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Company doesn’t go bankrupt:? A portion of my bond yield will be sufficient to cover the premium on my put (which I expect to be worthless at maturity).? The remaining bond yield will represent my profit.? My big risk here is mark to market losses where my bond gets hit but the equity hasn’t sufficiently sold off to make the put hedge perform.

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Bond yield – put premium > 0

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Company goes bankrupt:? I know the value of my bond in bankruptcy (recovery value).? I know this because I’m really good at analyzing the company or because I just referenced the value of the credit default swaps.? As the equity value goes to zero my profit on the puts will offset the losses on my bond.? My big risk here is getting the recovery value wrong or having the bankrupt stock trade higher than I expected it to.

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Put value + Bond recovery value > Bond losses

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The banks were in free fall and the market had just turned their attention to Morgan Stanley.? Bonds were getting hit and traders were looking for lifeboats.? Open interest on the 2.5 strike puts was exploding as bond holders rushed to hedge their positions.?

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20 cents

25 cents

30

40

50!

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I’m not sure if it was the actual bond holders or their risk managers that were forcing the trade, but the put buying seemed indiscriminate of price.?

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Relative to equities, credit guys usually swing a bigger stick.? This is because the volatility of their product is (usually) much lower, so they need to move larger notional values to move the needle.?

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This larger capital base translated to a tsunami of demand as their needs outstripped the supply in an already volatile market.?

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One thing they didn’t get right was the relative value of options pricing.? Being specialists in credit, their playbook mandated buying the lowest strike – not examining a comprehensive volatility surface to express the most efficient bet.?

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I didn’t have to look far to find a better trade.? The 7.5 strike puts were trading $1.5.?

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Mentally calculating break-evens is a great way to size up option risk in fast markets.? If I could pay $1.5 for the 7.5 strike while selling 3 of the lower strikes for 50 cents, I would have a premium neutral trade.?

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1.5?? = ??.50 * 3?

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Here’s the quick math for breakevens on premium neutral ratio spreads:

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1x2 ?(pronounced “1 by 2”) ???= ???the width between strikes

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1x3 ???= ???half the width between strikes

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1x2 Example:

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+1 ???100 strike call

-2? ????125 strike calls

Net premium = 0

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Since the strikes are $25 apart, my breakeven is $25 higher than my high strike

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Stock @ 150:

100 strike call = $50

(2) 125 strike calls = -$25 *2 = -50

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Breakeven: 150

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1x3 Example:

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+1 ???100 strike call

-3 ????125 strike calls

Net premium = 0

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Since the strikes are $25 apart and this is a 1x3 my breakeven is $12.5 above my high strike.?

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Stock @ 137.50:

100 strike call ?= ?37.5

(3) 125 strike calls = -12.5 *3 ??=? -37.5

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Breakeven: ?137.5

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Examining my MS put spread opportunity, I did the quick math:?

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1x3 breakevens are half the width?

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I was contemplating the 7.5 and 2.5 strikes, so my put spread had a width of 5.? This translated to a breakeven $2.5 below my short strike – aka zero.?

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I didn’t lose money on this trade until the stock was worth less than zero.? That seemed like a statistical improbability to me.?

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If the stock was between zero and $7.5 I would make money.? If stock was greater than $7.5, I didn’t make or lose as the spread didn’t cost me anything.?

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To me, this seemed like a binary situation:?

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1.????? MS would survive and the spread would be worth zero meaning I lost nothing.?

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2.????? MS would file for bankruptcy and the stock would trade with a residual value since bankrupt stocks rarely trade at zero.??

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I strapped on as many as I could get until the volatility surface started to normalize.?

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So how did that work out for me?

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Lehman went bankrupt a week later.?

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**? Hey guys…thank you for the positive feedback on the previous articles.? Curious if this one was too technical. ?

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