A Lynching to Cheer

The NYSE's has had its share of bad publicity recently, much of it well deserved, but the latest development is something that we can all cheer: the public lynching of so-called "front-runners." These are the floor-trading institutions who step ahead of their own customers to buy or sell stock more or less risklessly. One way they do it is by using the options markets. For example, XYZ Brokers might have a customer who wants to acquire a million shares of Ajax Corp, paying no more than $2.00 above a current market price of $45.25. "No problem," says XYZ, which immediately dispatches a floor broker to purchase 10,000 Ajax Corp January 50 call options, quoted perhaps at $2.00 on the CBOE. The options dealers smell a rat because of the huge size of the order, but when XYZ offers to pay a whopping $3.00 apiece for the calls provided they can buy all 10,000 of them at that price, the market makers figure it'll be hard to lose. No sooner have they finished writing up their "sell" tickets, however, than a million-share block of Ajax crosses the tape at $47.25. And guess who the seller of the stock is: XYZ Brokers, shorting all million shares to its customer, hedged by the 10,000 January 50 calls options they'd acquired earlier - acquired for far less, of course, than if the option market makers had known Ajax was about to take a $2 leap.

It gets even better for XYZ if the stock settles down and the brokerage firm is able to sell 10,000 January 50 puts for anything near fair value. This will lock in a "reverse conversion," allowing XYZ to reap riskless T-bill interest on the cash proceeds from the million shares of Ajax that they shorted to their customer. The specialists can play this game as adroitly as the brokers, since they are among the first to know when a buyer or seller is shopping a big order. Not surprisingly, the list of exchange specialists who have been charged with front-running by the NYSE recalls many familiar names from my market-maker days on the options floor of Pacific Coast Exchange. If you'd seen what I saw during the 12 years I traded there, you might be tempted to believe that practically every trade of size that goes down on an exchange floor is being front-run by somebody. The regulators never seemed to care when it was floor traders like us who were getting burned, but I'm glad to see that they're at last trying to clean house to prevent the public from getting ripped off too.

Remind me not to get involved in the stock market. I don't understand your description of frontrunning. But then, there's a lot I don't understand about the stock market.

So they buy call options, which I believe entitles them to buy the stock at a certain price (but at what price?). And then they sell short to their customer, meaning they haven't yet exercised the option and they don't actually own any of the stock yet. Right so far? So, if the stock goes down, they buy it at a lower price than their customer paid them for it. And if the stock goes up, they exercise the option to buy it at a lower price (but what price?). I still see an exposure of $3.00 per call option (is that per share?) Isn't there a gap in there where they can be hurt if the stock goes up but not enough to cover the cost of the option? This is all very strange. I have never traded in options, and never aspire to do so.

The brokerage in the example would be buying call options at a strike price of $50, for a premium of $3.00/share. At a premium of $3.00/share, each option contract would cost $300, since there are always 100 shares per contract.

In Ackerman's example, the brokerage customer wants to buy 1,000,000 shares of Ajax. To fill this order, the brokerage first buys 10,000 call option contracts, which exactly covers 1,000,000 shares (10,000 * 100 = 1,000,000.) The broker pays $300 per contract, or $3,000,000 for these options ($300 * 10,000 = $3,000,000.) These option contracts give the broker the option (but not the obligation) to purchase 1,000,000 shares of Ajax at $50/share--regardless of the current market price of Ajax.

Next, the broker borrows 1,000,000 shares of Ajax from someone else--usually from other customers of the brokerage who have the shares on account at the broker. You will find that most brokerage agreements give the broker the right to do this without explicitly getting permission from the customer. The only way to prevent this is to take possession of the shares yourself, instead of keeping your shares on account at the brokerage. When you buy shares from your broker, it is often (but certainly not always) the case that the shares you are buying are shares that the broker borrows from his other customers. So the broker then sells the borrowed ("shorted") shares in order to fill the customer's order for 1,000,000 shares of Ajax.

If the price of Ajax falls, the broker will lose money on the options, but make money on his 1,000,000 short position in Ajax. This is because he can replace the shares he borrowed for less than the amount of money he received for them from the customer who just bought the 1,000,000 shares. For every $1.00 that Ajax falls, he makes $1,000,000 on his short position. He loses far less than that on his option position. And once the stock has fallen by $3 or more per share, he's made at least enough on his short position to cover the full cost of the options.

If the price of Ajax rises, he loses $1,000,000 for every $1/share by which the price rises. However, the value of the options rises by roughly the same amount. And the broker will generally be able to incrementally close out his short position as he receives Ajax sell orders from his customer base. When a customer wants to sell Ajax, the broker simply hands them cash out of the proceeds he received for selling the stock short, and then takes the shares from the seller and returns them to the source from which they were borrowed.

And, as Ackerman points out, the broker can also purchase put options in Ajax, right after the price rises to $47.50/share due to the 1,000,000 share transaction that started this whole scenario, in the expectation that the price will soon "correct" back to where it was after the up-spike that the broker and his large-order customer recently caused.

You are correct as far as you go.In the above example,the stock is sold at 47.25 and the options($50 calls,give the call holder the right to buy stock at 50 until they expire) are bought for $3.This means the brokerage firm has $5.75 of risk(i.e.,if the the stock is at 50$ at expiration,the calls are worthless,and the short stock position has lost 2.75).In fact,if you sell a stock short and buy a call,you have what's known as a synthetic put.(You can see if the stock goes to,say,30,you will make 17.25 on the short stock sale,offset by a 3 loss on the call buy.This results in a profit of 14.25.You can also see that if you had bought the put outright for 5.75,at thirty dollars,it would be worth 20,or a profit of 14.25).

By selling a 50 level put after you had bought the calls and sold the stock,you would have what is known as a reverse conversion,relatively risk free,and a credit balance of 50$.At expiration,if the stock is below 50,you buy the stock via the puts that are assigned to you,and if it's above 50,you exercise the calls.Either way your short stock position goes away.

Frontrunning is just what it says.The brokerage firm is working a large buy order(say),and meanwhile accumulates stock for itself,to resell when the big order gets filled at a higher price.They are buying(or selling)in front of their customer's order.

By selling a 50 level put

Ah yes, selling (writing) puts. I see now that Ackerman said "selling," not "buying." Big difference. By selling puts, the broker can more or less cover the cost of the call options. As a result, the call options cover the risk of the broker's short position in Ajax. The puts pay for the calls. And the short position in Ajax covers the short Ajax puts! The result is that the broker can treat the money he received from the customer who bought the 1,000,000 shares in Ajax (the transaction that started this whole chain of events) as an interest free loan.

When you buy both puts and calls in the same underlying instrument, that's called a delta neutral trade. It's a good play when the market has been in a trading range, and you expect that it will soon break out one way or the other, but you aren't sure in which direction. You'll make money either way, as long the breakout goes far enough. But if the market stays in the trading range past the expiration date of the options, then you'll lose money.

Some other strategies:

Bull call spreads: Sell (write) calls at a higher strike, buy calls at a lower strike. This trade has an "net debit" initial cost, which is the premium for the calls you buy less the premium for the calls you sell. You make money if the price of the underlying asset rises enough so that the value of the long calls rises by more than the price you paid for the position. The most you can lose is the "net debit."
Bull put spreads: Sell (write) puts at a higher strike price, buy puts at a lower strike. This trade results in a "net credit" initial payment to you, which is the premium you receive for the puts you sell less the premium you pay for the puts you buy. If the market price rises, you get to keep the "net credit" you received for the trade. Otherwise, if the puts you sold expire "in the money," your maximum loss is determined by subtracting the spread between the short and long puts from the net credit you initially received.
Bear put spreads: Buy higher strike puts, sell (write) lower strike puts. This trade has an "net debit" initial cost, which is the premium for the puts you buy less the premium for the puts you sell. You make money if the price of the underlying asset falls enough so that the value of the long puts rises by more than the price you paid for the position. The most you can lose is the "net debit."
Bear call spreads: Buy calls at a higher strike, sell (write) calls at a lower strike. This trade results in a "net credit" initial payment to you, which is the premium you receive for the calls you sell less the premium you pay for the calls you buy. If the market price falls, you get to keep the "net credit" you received for the trade. Otherwise, if the calls you sold expire "in the money," your maximum loss is determined by subtracting the spread between the short and long calls from the net credit you initially received.

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