How Market Makers buy UNITS to stay in business

I want to take a few moments to flash all you option traders back to 2004. It was a fine year; I was living in Chicago, working for Group 1 Trading, making a fine living for myself. I had entered the Best Buy Pit to primarily trade Oracle’s hostile takeover bid of PeopleSoft (how many of you traders remember that)? As you recall, Oracle got People soft for 26.50 a share, and my life moved on to normal trading. One of the stocks I traded was a small Biotech company
called Elan that was developing a really cool Multiple Sclerosis drug called Tysabri. Apparently, this was going to be THE breakthrough drug for the disease. I enjoyed trading the stock because it was active, with really good back and forth trading. On February 26, 2005 I walked into my office, my risk manager stopped me and said “ELN is down 17 dollars” (see chart). This ended up being the single biggest one day gain I ever made on a single stock. Why? Because I was net long A LOT of ‘units’.

Units

Units are essentially valueless puts that provide protection in the event that the equity or index you are trading has a violent and unexpected move. In order to be a unit on an average equity stock ($20-$70 value in the underlying) the options must be: worth less than .25. The idea behind these cheap puts and call is that the value of the option has little or no bearing on the actual position’s success. In every trade there are 3 scenarios:

1. Being right
2. Being wrong
3. REALLY being wrong

For instance, let’s say that XYZ stock is trading 50 dollars. The trader sells 50 XYZ 50/45 put spreads and collects 3.00 of premium on each sale. The trader then goes out and buys 30 42.5 XYZ 42.5 puts for .25. Thus the trader’s position is as follows:

-50 XYZ 50 Puts

+50 XYZ 45 Puts

+30 XYZ 42.5 Puts

Let’s go over the 3 scenarios: Scenario 1, the trader is right. The trader will collect 14,250 dollars in premium. Scenario 2, the trader is wrong: If the stock drops to 44, the trader will lose 10,750 dollars. Now scenario 3, the trader is REALLY wrong, the stock drops to 38.00. In this case the trader lost 10,750 dollars from the put spread he sold. Here is the key to the Unit, the 30 42.5 puts he purchased for .25 are now worth 4.50. He made 12,750, on 30 very cheap puts. This is why traders should purchase these options.

Back to my story: My downside ELN position was pretty close to this (I don’t remember the EXACT position but this is my best guess as to what it looked like net across all the months).

+200 ELN 25 puts

-250 ELN 22.5 puts

+50 ELN 20 puts

+110 ELN 17.5 puts (these closed (or went out) at $0.10 as I recall)

The next day when the stock was trading 9.00 I had about 15,000 share of stock to buy. My take ended up being about $140,000.00.

How can we use this knowledge for indexes? Here is my approach: I will always spend about 5% of my total premium collected on some cheap puts. After I buy these puts, I actually ‘delete’ them from my position. I do this because I don’t want any of these options Greeks included in my calculations. Once the option reaches a delta of 25, I will then add it back into the position. If a trader is doing this deleting strategy it is important to look the total position in the morning to make sure that the position is still properly protected, but after doing so, I’ve found it much easier to trade excluding insurance unit puts.

I will be back from vacation next week Sunday; if you have any questions email me mark@option911.com, follow us on Twitter.

Your comments are always welcomed and encouraged.

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