How Markets Become Efficient II
Last time I described, in the context of a normal retail operation, the “handing off” of high return opportunities by market “wholesalers” to players who are happy with a lower return. Let’s look at the mechanics of this process in the options market.
When options first began trading on exchanges, most market players were fairly naive. Because of this, opportunities appeared that you will no longer find today, at least in the American markets. An example is the credit long butterfly spread.
A butterfly spread consists of a position in three option series with the same type (put or call) and expiration and equally spaced strike prices, where the ratio is 1 x 2 x 1. For example, a current butterfly spread in IBM is long one Dec. 80 call, short two Dec. 90 calls, and long 1 Dec. 100 call. The outside strikes, the 80 and 100, are called the “wings” of the butterfly and the inside strike position, the 90, is the “body’.
If the position is long the wings, the butterfly is called a “long butterfly” and the butterfly will typically cost something to buy and therefore will create a debit in your account; if they are short, it is called a “short butterfly” and the butterfly will typically bring a credit into your account. Both long and short butterfly positions have limited risk.
When the exchanges first began trading options, it was possible to find long butterfly positions that you could purchase for a credit; if you purchase a long butterfly for a credit, you cannot lose. It is free money. To illustrate the degree of naivete in the markets, not only could you find such positions, but you could purchase them occasionally directly from market makers themselves!
What happens when you discover such an opportunity? Naturally you try to do it as many times as possible, purchasing the wings and selling the body. Sooner or later, your activity will have an effect on the prices of the options: The wings rise in price in response to your repeated bids, and the body declines in price.
Suppose another trader observes the long credit anomaly after you do, and jumps into the fray. The rise in price of the tails causes them to cost the second trader more than what you paid, and the decline in price of the body causes them to deliver less premium to the second trader than they did to you.
The second trader pays more for the tails and gets less from his sale of the body, and so does not get as good a deal as you got. If prices move enough, you could cover your transaction costs and make a profit even selling your position to him. In fact, at some point you may simply sell out your entire position to the new trader and go on to other opportunities.
You will hand off this trade to another trader if the funds from the profit you make thereby can be put to higher return use elsewhere. If you look at the butterfly as one item with a cost, this is precisely the same process I described last time in the context of chair retailing.
Exercise: