THE STRIKING PRICE
He's Got Gamma
By STEVEN M. SEARS
The mathematical kind, that is. An ace trader suggests ways to invest
around volatility shifts.
JEFF SHAW IS PROBABLY the most powerful options trader you've never
heard of.
As senior trader for Timber Hill, the market-making unit of
Interactive Brokers (ticker: IBKR), he holds enormous sway over the
price of every put and call traded in the U.S. options market. His
judgments directly influence the prices of 1,700 stock and index
options -- which translates into real-time quotes on about 240,000
puts and calls.
And so many other traders reference Timber's prices to see if theirs
are correct, and that only amplifies Shaw's power.
Starting as an American Stock Exchange clerk, Shaw has been at Timber
since 1984. Now he has one of the world's most commanding views of the
options and stock markets -- from a small trading floor in a plain
building in Greenwich, Conn.
SHAW'S BEEN SEEING what most others have no way to see: During the
past week, institutional investors have started selling stock options
that expire in December 2010 and buying others that expire in
September and October 2009.
What does the action suggest? That some 2010 options are overpriced --
as implied volatility is so elevated as to suggest that the credit
crisis won't abate. Shaw says September '09 options' volatility on the
Standard & Poor's 500 Index is as much as 20% lower than that of
December 2010 options.
[CBOE chart]
The longer-dated index volatilities imply stock-market moves exceeding
2% each day through 2010. But that seems unlikely, amid nascent signs
of economic and corporate-profit growth.
So why the disconnect? The answer's to be found in
options-pricing-
"As the market slows down, that leads to lower front-month
volatilities, as pricing models used by most market makers sense that
historical volatility is dropping," Shaw says, yet "it takes more time
for longer-term volatilities to incorporate the recent relative calm
in their prices."
In October '08, during perhaps the worst of the credit crisis, the
Chicago Board Options Exchange's Market Volatility index (VIX) peaked
at 89. Volatility has sharply declined since then, lowering options
prices -- but the smoothing effect will not show up as quickly for the
longer-dated options.
This quirk leads some traders to essentially sell the future in order
to finance near-term positions predicated on the Standard & Poor's 500
Index's bursting from its 880-to-940 trading range.
To be sure, such trading isn't for everyone. But buried in these
complications of pricing models, and in the differences between
historic and implied volatility levels, is the thinking of some very
sophisticated traders, which can help investors better understand
market crosscurrents.
"Think of the market now as becoming a tightly wound spring," Shaw
says. "Eventually, it will break out of its range. And when it does,
owning gamma -- or short-term options that are more sensitive to price
movement -- will be profitable against long-term, higher-volatility
options."
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