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Who do you think is selling you the put option? Do you suppose they price those such that a trivial stock pair hedge will make money? If they did that they would be losing a ton of money & you would have replaced equity risk with counterparty risk as they go out of business.

HFT are good at options trading for the same reason all options traders have been throughout history. They can find misspricings in the market and trade them while they last. HFT is taking over those trades because HFT is much cheaper than the humans they replace & can therefore take on less high margin mispricings than humans can.

Also options trading is a regulated marketplace much like equities & commodities trading.

Finally 'yummyfajitas is an ex-HFT who has written good blog posts on the subject.

>"Do you suppose they price those such that a trivial stock pair hedge will make money?"

The example was just for illustration purposes, a simplified version of how it works.

>"Also options trading is a regulated marketplace"

Is that right?

https://en.wikipedia.org/wiki/Derivative_(finance)#OTC_and_e...

"Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options – and other exotic derivatives – are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts is difficult because trades can occur in private, without activity being visible on any exchange."

>"Finally 'yummyfajitas is an ex-HFT who has written good blog posts on the subject."

I would welcome yummyfajitas 's feedback. I'm not attacking yummyfajitas, if that's what you're implying.

> The example was just for illustration purposes, a simplified version of how it works.

Sure, but real options trading is much, much more complicated than that. You might as well have said "Find an equity that you know is underpriced and buy that". There is no secret sauce in options trading for HFT or otherwise. Like any market based trading profession you find a place you think is incorrectly priced, you take a position, and then you either make or lose money. The more often you are right the better a trader you are. There is literally nothing special about options trading vs equities trading in this regard (except maybe leverage as options can be dramatically leveraged).

> Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties

You could do private options I suppose (but HFT would have a distinct disadvantage here), but most options are traded on exchanges (I believe CBOE is still the biggest options exchange in the US) just like any other exchange traded instrument. The SEC, FINRA and CFTC all have rules about options trading in the US.

> I'm not attacking yummyfajitas, if that's what you're implying.

I didn't mean to imply you were attacking yummyfajitas, only that he probably knows about options pairs trades given that they are a very common trading pattern for anyone who has worked in the trading industry, HFT or otherwise.

You can lose because the option price takes into account how much the market expects the stock to move (the implied volatility). Your proposed strategy is going long volatility and delta-hedging to maturity.

Others have already chimed in, but I'll use a real life example. At the close yesterday, NFLX was trading around $100, you could buy a put option to sell with strike price $100 expiring December 18th 2015 at a price of around $7.00 a share.

Using your strategy, you would buy one contract and simultaneously buy 50 shares. Each contract comes in multiples of 100, so your put option covers 100 shares and you own 50.

If you didn't manage the trade at all until December 18th, you'll make money if NFLX is below $86 or above $114. You'll have lost money if it is anywhere between the two numbers, because the actual realized volatility of the stock did not live up to the implied volatility price (and for many reasons that is usually the case).

Even if you did manage the trade throughout, there is no easy free lunch. You could set a rule to close the trade the moment NFLX crosses over $120 or under $80, but then you'd be giving up the upside that it hits $150 or $50.

I'm a beginner to this field, but using a real world example sounds like a good way for me to learn, so thank you for putting it together leelin.

I'm a bit confused by some of the terms used (such as implied volatility price, can you explain what this means?), but assuming I've followed enough to understand... If the put option covers 100 shares, why would you only buy 50? Wouldn't it make sense to buy 100 shares?

You buy 50 shares, because in your proposed strategy you want to make money whether the stock goes up or down. Because the option strike price and underlying price are the same, the appropriate ratio of underlying stock to options is about 50% if you want to be neutral to the future direction of the stock movement (delta-neutral as they say).

If you bought 100 shares with 100 covered, then you are purely betting the stock is going up by more than the option price. You would break even at $107, but lose on anything lower.

Implied volatility is the amount the stock is expected to move as implied by the price the market is charging. Sometimes it is easier to think of an option price in terms of volatility rather than raw dollars, especially when you are making trades of the type you proposed.

In the Netflix case, the current price of the option "implies" that the stock will move plus or minus 3% per trading day; if it moves more, say 5% a day, you are likely to make money.

Of course, thinking of options in this way also means you are on board with a ton of assumptions in modern options pricing theory, and lots of smart people point out flaws and objections.

Okay, I understand about the 50 shares now, and the rest of your descriptions of how this work makes sense too, thank you for explaining this clearly.

Going back to NFLX example, I have one more question. You said that NFLX was trading at $100 yesterday, so where does $7.00 a share come into play? Are the shares not $100 a piece?

$7 is the option price. The interest in your earlier example.

Ah, thanks kasey_junk.

Okay, so I thought I knew enough to work the NFLX example, but I still came up with some mistakes. Unexpected values shown in blue here:

http://oi61.tinypic.com/2h71ndh.jpg

I've probably made a fundamental error, what am I missing?

Don't execute on out of the money options. IE you eat the $700 in fees but you don't actually trade the underlying stocks they represent.

Oh, so you can just pay the fees, cancel the put option, and keep the stock you bought at the beginning of the process?

Or really sell the stock you bought at the beginning of the process if you want to take profit.

Yes, that's one option.

So just so I understand, what flexibility do you have as the purchaser of the put option when it comes to selling. From what I understand the purchaser can choose to sell between the put option maturity date and the put option expiry date, is that correct? Are these typically the same date? Would you pay a premium to have a wider gap between the maturity date and expiration date?

The major difference between OTC and exchange traded derivatives is that exchange traded ones have set contracts that standardize these things. What those set contracts are is exchange to exchange and product offering to product offering.

You can take a look at CBOE's product web page to get an idea about the different kinds of options products they offer.

Taking into account put call parity, you've claimed you can beat the market by buying call options. Since you buy the call in one transaction you avoid all risks from delays regardless of being an HFT. Best of luck with that, let me know when you become rich.

Some HFTs do stat arb on put call parity, though I would hardly call such a strategy "can't lose".

The bit which is likely untrue is "you can game the system to move the odds in your favour." This bit is entirely unsupported by the rest of your comment.

Nothing you said is untrue; you just made it feel like math is some magic pot of gold.

Nearly every time, the cost of the stock plus the cost of the put option will be exactly the same as the values of all expected outcomes.

> "Nearly every time, the cost of the stock plus the cost of the put option will be exactly the same as the values of all expected outcomes."

Can you explain this further? Are you suggesting that you're obtaining the put option and the stock from the same source?

Yes. You would be purchasing both stock and the option from "the market."

As much as I like to joke about retiring to some farmers market to handcraft artisanal equity options, when people are talking about options on stocks (equity options) they are normally referring to exchange traded deriviatives.

> "Yes. You would be purchasing both stock and the option from "the market.""

Does "the market" include OTC derivatives, i.e. options not traded on an exchange?

Depends on the context. But in order to get OTC options you are going to need to be doing some sort of massive deal (AFAIK never done OTC derivatives trading) or it needs to be some sort of esoteric option contract. You wouldn't do this as part of a normal equity/option hedge or trade. You also would almost certainly be paying a higher price for the privilege than you would on an exchange.

Buying a "normal" option contract on an equity is almost certainly not an OTC deal and is instead exchange traded. Those exchanges are very efficient like the equities exchanges are so options are priced competitively (thanks to options traders).

Sure you can get industrial futures contracts, but don't you think your kids health deserves my free range, certified organic front month crude?

It's very easy to lose. Flash crash, transaction fees, your underlying model assumptions suddenly failing. Maybe you simply are doing worse than the S&P which is a failure in itself.