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To: Robert Graham who wrote (10758)	5/11/1998 1:02:00 PM
From: Robert Graham	Read Replies (2) \| Respond to of 14631

Today after reviewing my post on the techniques a MM uses to hedge their open positions, I see one mistake I made, along with being remiss in not mentioning some types of spreads that are a more preferred choice used by the MM to hedge their open short CALL option position. First, when I said that purchasing stock on open short CALL position is an incomplete hedge, this statement was correct but for reasons a little different than I have originally stated. Purchasing the stock would create a covered CALL position. If the stock went up where the short CALL position became in-the-money, the CALL would be exersized by the holder and the MM would deliver the stock at no net loss. This assumes that the amount the MM made on writing the options covers his carrying costs and commissions on the stock that he purchased. If the stock went down, even though the CALL option would not be exersized by its holder, the MM is left with stock that is valued less than its purchase price. If the stock went down far enough, the premium on the CALL option that he wrote would not cover the loss in the value of the stock. This would incur a net lost for the MM. This is why the purchase of stock to hedge an open short position in a CALL option is an incomplete hedge that is considered to have unlimited downside loss, or at least enough where it can wipe out a substantial part of the MM's capital. This is why it would be necessary to convert this position into a synthetic trade by purchasing PUT options to make it a "riskless" trade by being a complete hedge. Now there are different types of positions that are classed by the type of risk. First, there is the unlimited risk position where if the underlying stock moves in one direction up or down enough, the losses can be substantial. This is the case for the covered call position and the outright short CALL position. The next type of position is a hedged position of limited risk. This is the case with the vertical spread position that I had mentioned in my previous post, which technically can be either a credit or debit spread. The risk here is limited to a fraction of the difference between the short CALL strike price and the long CALL strike price. As mentioned before, there is the "no risk" type of hedged position of the synthetic. The downside here is commissions and carrying costs of the underlying stock itself, and this type of position still does has its own potential risks on synthetic positions that ar at-the-money on the expiration day called "pin"risk. Furthermore, legging into a synthetic position may not be workable in a given options situation because for instance of a unavailability of PUT options at the same strike price as the short CALL option. This can happen when the speculators are bullish on a stock that ha broken out into an uptrend for instance. There is another type of spread that may be more desirable than the credit spread mentioned in my previous post. This is the time spread. A time spread used as a hedge is where the MM purchases a CALL option that has the same strike as the short option position, with a later expiration date like one month further out. The advantage of this type of spread is that the losses that can result from he change in price of the underlying stock has been limited further. The best type of hedge other than the "riskless" synthetic trade is a spread that is completely buffered from any changes in price of the underlying stock. This is called a limited risk delta neutral hedging strategy. One example of this is the short straddle where a PUT option is purchased with the same strike price as the short CALL. This assumes that PUTs of the same strike price are available which may not be the case. All delta neutral strategies like this rely on the purchase ot and therefore availability of PUT options. There is one type of risk that specifically relates to spreads which I have not mentioned so far which is skew risk. The price of each option that has a time premium is based on in part the anticipated move, or volatility, of the underlying stock, which may be different than the historical volatility of the stock. This is called implied volatility when it is priced into the option. This implied volatility is taken into account by option pricing models used by traders and MMs as a tool to help them assess the "fair value" of the option. However, the price of one option of the spread may be over time based on an implied volatility different from that of the second option of the spread that is not provided for in the option pricing model. This skew risk has a cost associated with it that comes into play when entering or exiting a spread position. As you can see, the MM has different hedging strategies available to him that have their own associated risk and costs associated to them. Also one hedge position may be favored over another hedge position depending on the current and anticipated trading activity on both the options and the underlying stock. This is indeed a complex business. But it is also important to note that there is no hedge position that is entirely free from costs and/or risks. Such is the nature in the market making of options, which is to constantly balance the up front costs of their positions to the risk of incurring additional costs that can turn out to be substantial, and to make a profit in the end with a derivative that can take on a life of its own apart from its underlying stock. I welcome any comments or feedback on this topic. Bob Graham

To: Robert Graham who wrote (10758)	5/11/1998 7:46:00 PM
From: Gary Leger	Read Replies (1) \| Respond to of 14631

Robert, One comment about your second to last scenario of downward pressure on a call options: I agree you shouldn't sell your option if you're not getting "intrinsic" value but you have it backwards on the strategy- you would exercise and sell the common on an in the money call, not short; and short an in the money put you are naked. You would buy stock when you are long an in the money put. Your point is true in the sense that often one must close out the option position by working with the common.