Sunday, February 2, 2014

super bowl and option spreads

today is the super bowl and all thoughts on this day turn to the "spread."  the spread is a fudge factor in a sports wager whose purpose is to balance out the betting on the outcome of the game. you see, often times, there is one team that is heavily favored to win an event like the super bowl and this becomes a problem for bookies because they would have to not offer the win side of that bet for fear of getting wiped out. and what is the fun of that? so to encourage more betting participation the bookies have created a system to even-out the odds of winning a bet on the heavily favored team - the favored team must win by a number of points in order to win the bet. this number of points is called the spread and sometimes it is called a line. in offering spread betting the bookie is operating more like a market-maker than an odds-maker, like the kind of bet one places on a horse-race.

you see, what determines the spread is the activity of gamblers, not so much the bookies. when the bookies see that their book is getting lopsided they change the spread to encourage more betting on the other side. an absolutely balanced book means the bookies simply transfer money from losers to winners - making their cut on transaction fees, low risk and really rather mechanical. the bookies, instead of exerting a house advantage (see, eponymous book by jeff ma in my brane fud section), function more like market makers, simply facilitating wagers for a fee.

one can check the spread online because sports gambling is legal in certain states and countries. as of 11am today the spread on tonight's broncos vs. seahawks game was 2.5 points in favor of the broncos, meaning, the broncos must win by 2.5 points to beat the spread. this is pretty narrow, less than a field goal, so tonights game is viewed by gamblers as being fairly evenly matched.

there is something very much akin to a betting spread in the options market that comes into play during market events. in the world of options the events that generate interest like this are earnings reports. now, one might think that the analyst expectations for earnings of a company would be a kind of spread but these really reflect the opinion of a small number of people who may or may not be biased by who is or is not paying them. instead, the spread on a company's earnings report can be determined by an option strategy called a straddle.

buying a straddle means purchasing a call and a put at the same strike and same expiration. usually the strike chosen is an at-the-money strike. here is what the risk profile of a straddle looks like for kors (last: 79.93), which reports earnings tuesday morning:
kors straddle expiring in 6 days
the current market price of this straddle is $7.5 which means that if you bought this straddle at this price you would need kors to move more than $7.5 up or down from the last price of 79.93, by next friday, to be profitable. so you would need kors to beat this spread by that much and, like a football spread, this is determined by market particpants bidding up the price of the options.

personally, i hardly ever initiate a transaction to buy a straddle because it is at best a 50/50 proposition. market makers recognize that particpants overpay for options near earnings reports and they actually have a rule of thumb that says that the expected move in the market is really about 85% of this straddle price or $6.38. so the better bet is to sell this straddle but that has unlimited upside risk and nearly unlimited (bounded by zero) on the downside. this 6.38 market-maker expected-move is important to us premium seller's when we construct trades to take advantage of the volatility crush after earnings. (see tastytrade's trade-small-trade-often segment for examples of such trades.)

good luck on the super bowl tonight and may the odds ever be in your favor!

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