When stock is sold short, the purchaser pays cash for the shares, just as with a normal stock purchase transaction. In the case of shares sold short, however, the cash goes to the stock lender rather than to the stock seller. The stock lender holds the cash as collateral and invests it in Treasury bills or other cashlike, liquid investments. In the unlikely event that the stock borrower defaults, the stock lender could use the cash held in escrow to repurchase the shares and thereby repay the stock loan.
The existence of cash held in escrow is significant because of the interest it earns.Professional traders registered as broker-dealers, including option market makers, however, do receive a portion of the interest income. Short stock rebate is the portion of interest income generated by short stock positions that professional traders receive. The interest income from short stock rebate affects the pricing of option arbitrage strategies discussed in Chapter 6.
Typically, an option market maker receives 80 percent of the net interest generated from a short stock position, and the stock lender receives 20 percent. Therefore, if 100 shares are shorted at $90, then $9,000 of cash is generated,which, if invested at 4 percent annually, earns $6.92 per week ($9,000 0.04 52 $6.92), and an option market maker would receive 80 percent of this, or $5.53.
While this sum may seem inconsequential at first glance, consider that option market makers can accumulate positions involving thousands of options and millions of shares. With complicated details, suffice it to say, for option market makers, this interest amounts to an important source of income or expense—because they also borrow.The guiding principle governing interest income from short stock rebates is that cash held in escrow by the lender must equal 100 percent of the current stock price.
Cash transfers, therefore, are made each day between stock borrowers and stock lenders as the stock prices fluctuate. Declining stock prices lead to lower escrow deposits, which frees up capital and lowers costs for option market makers. Rising stock prices, however, increase escrow requirements. If a market maker must borrow more to meet these escrow demands, then costs can rise faster than interest income.
Profit/Loss Diagrams: Figures 1-1 through 1-12 illustrate basic to advanced option strategies that all experienced option traders should understand. Profit and loss diagrams show three important aspects of a strategy: the maximum profit potential, the maximum risk, and the break-even point. Highlighting these aspects helps a trader make the subjective decision as to whether or not the underlying has a sufficient chance of passing or not passing the break-even point and therefore whether or not the potential profit is worth the monetary risk created by the strategy.
Figures 1-1 through 1-4 present the four basic strategies of long and short calls and puts, the four building blocks of more complicated strategies. These figures each contain three lines. The lower line (straight) illustrates the profit and loss of the strategy at expiration. The upper and center lines (curved) show profit and loss at 60 and 30 days prior to expiration, respectively.Figure 1-1 illustrates the long call strategy, which has unlimited profit potential, limits risk to the premium paid, and breaks even at expiration at a stock price equal to strike price plus premium paid.
For example, a 100 Call purchased for 4.00 per share carries a maximum risk of 4.00, and the break-even point at expiration is a stock price of 104. Above the break-even point, the long call has the potential for unlimited profit.
Figure 1-2 shows that the short call strategy is the mirror image of the long call. The profit potential is limited to the premium received, whereas the risk is unlimited.
The short call also breaks even at expiration at a stock price equal to strike price plus premium received. If a 100 Call is sold for 4.00 per share, then the maximum profit is 4.00, and the break-even point at expiration is a stock price 104. Above the break-even point, the short call has the potential for unlimited loss.The long put is illustrated in Figure 1-3. A long put holds the promise of substantial profit because the underlying price can drop to zero, whereas it limits risk to the premium paid.
Buying a put breaks even at expiration at a stock price equal to strike price minus the premium paid. The risk of a 100 Put purchased for 3.00 per share, for example, is limited to that 3.00 per share, and the break-even point at expiration is a stock price of 97. Below the break-even point, however, the long put has substantial profit potential as the underlying stock declines toward zero.