\ okitility traders are from time to time accused of causing abnormal stock price movements or market manipulation. To see why it would make sense to manipulate a market, consider the situation of two
Figure 7.12 Complex combination #4
traders; one long volatility and the other short volatility. To make the illustration simple let us assume that the respective portfolios contain only one option—the
$100 stock call option, hedged with stock. Let us first consider the situation of the long volatility player. Fie is long the call option and short the underlying. Fie hopes that from inception to expiry the underlying stock price fluctuates wildly. If the fluctuations occur around the exercise price, his profits will be even greater. With the stock price near the exercise price, the gamma will be maximum, necessitating a large number of rehedging trades, each one locking in a profit. Now consider the situation very near the expiry date, say with only one week or only one day to go.
Options suffer the most time decay in the final stages of life and particularly if the stock price is near the exercise price. There is always the danger that if the option is still at-the-money by this final stage, that the volatility will suddenly die. The worst case scenario for the long volatility player is for the option to expire at-the-money (see Figure 4.16). The individual has a vested interest in the option expiring either in-the-money or out-of-the-money, particularly if the final price move is sudden.
To see the profits that can be made in the final stages of an options life consider the situation, if with one day before expiry, the stock price is $99.9 and the portfolio is long 100 options. At this price and assuming a volatility of 15%, the option will be priced at $0.27 and have a delta of 0.45. The option will be hedged with 0.45 x 100 X 100 = 4,500 short stock units. The option portion will be worth 0.27 X 100 x 100 = $2,700
and this will be the sum lost if the stock price is at or below $100 on expiry. If the stock price suddenly moved either up or down before expiry and the hedge was left unaltered, a significant profit would result. Table 7.11 shows the profits with two different price moves.
So the holder of this portfolio would be very pleased if the stock price suddenly moved away from the exercise price just before expiry. Rather than hope for natural causes, some players have been known to help the stock price move by either putting in large buy or sell orders just prior to expiry. In some cases the market may not need much of a nudge when one remembers that for every long option position there is also a short option position and if the other side of this trade is a short volatility portfolio then pushing the stock price one way may have a chain reaction effect. To keep delta neutral, the individual short of volatility must sell stock if the price falls. In the above example if the stock price is pushed from
$99.9 to $99.5 this may be enough to trigger a sell signal from the short volatility player. Further selling may trigger more selling with the result that the price may fall significantly by expiry. And this may all have been started by the long volatility player putting in a relatively small sell order.
The interesting point about the issue of market manipulation is that the long volatility player, by definition, should buy if the underlying price falls and sell if it rises. To manipulate a stock price down he must sell into a falling market and to manipulate a stock price up he must buy into a rising market—exactly the opposite strategy the trade dictates. So if a long volatility player decides to manipulate the market he must be sure that the costs of manipulation do not exceed the projected profits.
Now consider the other individual—the short volatility player. His best possible scenario is for the option to expire exactly at-the-money
Table 7.11 Expiring profit to long volatility trade (portfolio == long 100 options at $0.27 and short 4,500 stock at $99.9)
Stock price down to $98 Stock price up to $102
Option 100 X 100 X (0 0.27)
(see Figure 5.6). In the final stages of the option's life it is in his best interests to manipulate the stock price so that it stays as near the exercise price as possible. If the stock price begins to fall away from the strike price then he would need to buy in order to try to support the market and possibly bring the stock price back up to the exercise price. If the stock price begins to rise significantly above the strike price, it would be in his interest to sell stock in order to stop the rise and possibly force the price back down again. But in order to stay delta neutral, a short volatility player should be selling on the way down and buying on the way up. If he decides to manipulate the market, the short volatility player, like the long volatility player, is breaking the rules that will keep him delta neutral and such action will result in an exposure to directional risk. Manipulating the market can result in losing large sums of money.
There is definite evidence that in some markets, options expiry coincides with unusual price moves. In the US index options markets, certain expiry days, when more than one type of option expire, are referred to as triple witching days. In the early 1990s large players involved in the Nikkei 225 Index Options Market in Osaka were responsible for moves of up to 5% overnight. Often two opposing investment houses would take huge positions in options with just 12 hours of life left and place huge buy or sell orders in the underlying equity markets. On expiry one house would make $20 million at the expense of another and at the next expiry the same house would lose $20 million. To the smaller individuals in the market, it was like watching the clash of the Titans.
Probably the most famous example of market manipulation is the one that caused the downfall of England's oldest merchant bank— Barings. By February 1995 the Barings trader in the Nikkei 225 Index Futures and Options pit in Singapore (the SIMEX market) had acquired enormous short positions in index options. These options were exercisable into index futures contracts. (We do not intend to go into the details of futures contracts here but just note a long futures contract has exactly the same risk as a long position in the underlying basket of stocks. If one is long a futures contract and the market falls then losses will result.) The trader had a huge short volatility position—possibly the largest short volatility position in equity options ever held by anyone. The previous year had been one of the most stable in recent times. The Nikkei 225 Index had traded in a very narrow range of + or -5% for over six months and the trader was
betting that this would continue. Unfortunately on 25 February an earthquake struck mainland Japan.
Equity fund managers were puzzled when the Nikkei 225 Index Futures Market did not immediately fall. The earthquake was believed to have serious implications for equity market valuation and most participants expected a fall of at least 5%.
Many had begun to sell futures heavily in the expectation of a market crash and were bemused at the ease of execution—there seemed to be a mysterious buyer, and a buyer in very large size. The Barings trader was very short volatility and if the market had fallen, would have had to have sold enormous numbers of futures contracts to stay neutral. Fte realised that his rehedging activity would have to be so large that it would have precipitated an even larger market crash than was expected as a result of the earthquake and so he decided to try to manipulate the entire Japanese equity market—he bought futures rather than sold. And this was why the market did not immediately fall. The Barings trader was buying in the face of the large selling pressure from all over the world. It worked for a few days.
Over the course of the next week the Barings trader accumulated tens of thousands of long futures contracts in an attempt to prop up the market. Eventually the trader ran out of money and in his own words, could no longer support the market. When the problem became public knowledge, the rest of the market knew that the Bank of England (on behalf of Barings who were in liquidation) would be a panic seller and the market promptly dropped 1,000 points. To date the losses are estimated to be £860 million and the fiasco sent one of the world's most respected banks under.
And all because of a short volatility trade that got out of hand. It may be possible to manipulate a given stock but to try to hold up the world's second largest equity market against natural forces was very ambitious.
There is a final point worth making in the wake of the Barings collapse and that is the question of the losses. The media at the time were obsessed with the size of the losses and they certainly were very large. But no one seems to have mentioned the profits. The futures and options business is a zero sum game. For every dollar lost there is a dollar made. If Barings lost £860 million then someone made £860 million and no one seems to have bothered to mention this. Barings were short volatility to the rest of the world being long volatility and these individuals quietly banked their profits. No money was lost. All that happened was that £860 million changed hands.