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Sure, you can "borrow" or "lend" money with the pit using boxes and
conversions. They are riskless (except for pin risk at expiration) and
given the right circumstances, you can do them for better than value. How
much better than value you can do them will yield a higher "interest rate"
when you lend or vice versa when you borrow. I have never been able to get
the edge on a conversion or box off the floor, but as a floor trader, it was
not uncommon in the bond pit. Many floor traders make their livings legging
into and out of conversions and boxes.
As a very short lesson:
I could do a conversion trade by going long 1 March Bond future at 121-00,
short 1 March 121 call, and long 1 march 121 put. Typically this trade
would be done at "value" (we'll assume we are near expiration and value is
"even" for now) and would be executed all together as a package in the
pit. Prices for the options would be the same. But sometimes you could do
the conversion for 1 tick or more difference from value. For example, Long
1 future @121-00, short 1 call at 61, long 1 put at 60. This is getting 1
tick edge and it is free money. Around expiration, though, these can be
risky (pin risk). If you have one of these conversions on and just before
expiration, the market is "pinned" around 121-00, you don't know whether to
exercise your long put because you don't know if the short call will be
assigned to you. It can be VERY hairy.
The value for the conversion is related to the time to expiration. i.e If
you are a bond option trader and you are looking at a X day option and you
figure your cost of capital on a conversion is 6% which translates into $50
per contract(3.2 ticks), then you might make a market 3 bid at 4 for the
conversion. If you sell it at 4 then you have loaned money to the pit at a
better rate than 6%. (you can do the math)
Sometimes, especially in unstable economies, different market participants
have drastically different costs of capital and trading in these conversions
is very profitable for both. I have been told that in the past, banks in
Brazil, for example, have done alot of these trades in the pits down there
because the marketmakers are employed by multinational banks and have lower
cost of capital than even the Brazilian banks do. The traders willingly
loan out their bank's capital and make a profit in their book. It isn't the
best use of the bank's capital, but the trader doesn't care (he just wants
his bonus) and the bank rarely notices.
Anyway, those are some things that I remember.(I think I remembered them
correctly)
Eric
Michael E. Strupp wrote:
> Dear Options Traders From Around The World:
>
> I'm currently taking a course on futures at the Illinois Institute of
> Technology, and as part of a mid-term exam, we were given the following
> tricky question:
>
> "Can Options Spreads Be Used To Create Synethic Loans?"
>
> Now, I'm a bit stymied by this question, and as I understand it, it is
> asking whether there is someway to capture the cost-of-carry (which, for
> a commodity like gold, generally exhibits a full cost-of-carry forward
> curve) by using options. My initial answer to this question is yes, and
> I would capture the cost-of-carry by creating synethic futures from
> options for different expirations and then trading between them but I
> can't quite figure out how it would work.
>
> Any suggestions from any options gurus out there?
>
> Thanks!
>
> Michael Strupp
> Chicago, IL
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