32 lines
2.1 KiB
Plaintext
32 lines
2.1 KiB
Plaintext
finance the long stock. This is proven mathematically by put-call parity.
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Negative rho indicates a bearish position on the interest rate; the trader
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wants it to go lower. Positive rho is a bullish interest rate position.
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But a one-percentage-point change in the interest rate in one day is a big
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and uncommon change. The question is: is rho relevant? That depends on
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the type of position and the type of trader. A 0.090 rho would lead to a
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0.0225 profit-and-loss (P&(L)) change per one lot conversion on a 25-basis-
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point, or quarter percent, change. That’s just $2.25 per spread. This
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incremental profit or loss, however, can be relevant to professional traders
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like market makers. They trade very large positions with the aspiration of
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making small incremental profits on each trade. A market maker with a
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5,000-lot conversion would stand to make or lose $11,250, given a quarter-
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percentage-point change in interest rate and a 0.090 rho.
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The Mind of a Market Maker
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Market makers are among the only traders who can trade conversions and
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reversals profitably, because of the size of their trades and the fact that they
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can buy the bid and sell the offer. Market makers often attempt to leg into
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and out of conversions (and reversals). Given the conversion in this
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example, a market maker may set out to sell calls and in turn buy stock to
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hedge the call’s delta risk (this will be covered in Chapters 12 and 17), then
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buy puts and the rest of the stock to create a balanced conversion: one call
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to one put to one hundred shares. The trader may try to put on the
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conversion in the previous example for a total of $0.50 over the price of the
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long stock instead of the $0.46 it’s worth. He would then try to leg out of
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the trade for less, say $0.45 over the stock, with the goal of locking in a
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$0.05 profit per spread on the whole trade.
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Reversal
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A reversal, or reverse conversion, is simply the opposite of the conversion:
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buy call, sell put, and sell (short) stock. A reversal can be executed to close
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a conversion, or it can be an opening transaction. Using the same stock and
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options as in the previous example, a trader could establish a reversal as
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follows: |