Philip M Halperin - Scribblings

 

 A Couple of Calculations Nobody Ever Makes

  Bid-Offer Breakeven

This one is actually trivial, but very instructive in talking to spec traders, and has wider implications in terms of the optimal option position to take in a particular market. One of the bits of folklore among old options traders is that 30 delta paper is the 'best' paper to buy for a particular purpose, because it doesn't hurt too much and accelerates quickly in your direction. I contend that, like any other old canard (including mine) this is probably wrong. The bid-offer spread that a price-taker faces should be a major determinant of which strike to buy. And an index of how powerful your option is is a function not only of the delta, but also of the bid-offer.

Simply put, we can define a bid-offer breakeven thus:

Breakeven = (O - B) / d

Where

  • O= the offer price of the option,
  • B= the bid price of the option,
  • d= the option delta calculated correctly

Stated in English, take the dollar distance (premium difference) between the offer and the bid, stretch this by the delta, and you know how far the underlyng must move *today* just to get out of the option at flat.

The implications of this are also fairly obvious: The more illiquid the market, the greater the distance between the bid and the offer. The greater the distance, the higher the delta must be for the same degree of responsiveness to a move in the underlying.

A few minutes of playing with this calculation in different markets should convince you that you should not mindlessly buy the same delta paper in all markets, but rather should temper this strategy by the effect the bid/offer will have on your profitability. This applies for directional options specs.

For non-directional types, making money through the options gamma becomes a question in the first instance of the likely fluctuation of the underlying, adjusted by the bid-offer spread in the underlying itself.

Coming soon:

Ratio Spreads and the Generalised Butterfly

FX Volatility Parity

 

ęCopyright 1998

 

Back