What Are You Betting On?

Good Morning!

This is the Jumping Cholla (CHOY-uh). The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!

And even if you don't trade, learning how to think like a trader builds a robust framework for problem solving, taking risks, managing a plan, and just living life.

Quote of the day:

"A bet is a risk in search of a reward"

And when you get that reward, GTFO!

In options, your risks morphs as time, underlying, and volatility changes. You need to consistently reassess the exposure your options are giving you and manage away the stuff you "don't want to bet on."

Today, we'll go over a little straddle trade we did yesterday to highlight the morphing from a non-directional “movement” bet to a highly directional bet.

For you sports betters out there, this is like betting on the “over” at the start of the game, and halfway through the game your bookie calls and says “actually, pick a team you think will win.”

What would you do in that situation?

BANG for Your Buck:

Here at the Jumping Cholla, the BANG is our translation of option volatility into potential underlying movement. In gambling terms, this is where option bookmakers "set the line."

Large Option Positioning

• 4200 strike creates large positive gamma for dealers and will act as resistance above and a magnet below.

• Staying above the 4100 strike perpetuates the bullish lean.

• A breach of 4100 will likely test the option support at the 4000 level.

• 3900 strike creates large negative gamma for dealers, which will exacerbate movement near there. In general, a break under 4000 gets the dealers to start hedging with the direction of the market and a pop in volatility.

• Overall, "downside protection" i.e. puts, are priced historically cheap. But remember, there's a sh*tload of liquidity in ultra-short dated options, and as long as the marketplace can take these bets, what's the real need for longer dated hedges? Why not just wait until you need to buy the insurance?! (FYI, this works until it doesn't!!!)

• VIX Trades: large trades occurred that essentially bet that volatility will go up precipitously into March. FYI, with the current stance of option open interest, volatility can't really increase massively until the SPX is under the 4000 level.

News/Reports

• What did we tell you yesterday?! Our boy J-Powell had the potential to move markets, and boy oh boy, he did not disappoint! When he be talkin’, you be tradin’!

• The next big "number" is Feb 14th CPI (i.e. is inflation getting better or worse)

Is the Straddle Cheap?

A straddle is buying a call and a put at the same strike. Here’s how it “looks”:

The value of the straddle is on the vertical axis, and underlying prices are on the horizontal axis. As you see, the underlying needs to be much higher or lower for this bet to pay out.

The green curve is the value of the straddle ~ 5hrs before the end of the day. The yellow area is the “time value” or extrinsic value, which will disappear as the day goes on. And eventually turn into the grey “V,” which is what the straddle will be worth at the end of the day.

I thought the 4100 straddle (“betting the over”) was cheap at the time. With this bet, I am predicting that the market will move more than 37 handles in either direction before the end of the day.

Here are a couple reasons why I thought it was cheap:

• We ended the day prior with a BANG of 50.

• The only real market moving event is J-Pow speaking at ~11:30a CT

• Volatility won’t decrease until the “event” is over, so the straddle should hold its most of its value at least through the event. I.e. this trade should be easy to “scratch”

• If volatility decreases rapidly, the up move will get exacerbated due to dealer hedging dynamics. Quick recap: as volatility drops, dealers are over-hedged and need to buy back the underlying to remain “market neutral”. See our write-up about event volatility from the other day.

• If we sell off, we will start approaching an area where dealer hedging will exacerbate market moves. Remember COPS?

Notice, I am thinking about why I want to “bet the over,” why I think I can profit, and why I can probably exit for limited loss.

What is the one thing I don’t mention?

Direction. I do not care which way the market goes, it just has to move. I am not betting on a team, just that points will be scored!

So, the SPX underlying is around 4100, and I buy the straddle for $37.00. (FYI, in dollars, a 1 lot is $3700) I have no clue where the market is going, but I think it’ll go at least 37 handles higher or lower. (I won’t even get into my plan to gamma scalp by selling calls and puts against it)

Let’s see what happens.

The bottom pane is volatility. Notice how stable it is until the event. This is exactly what we anticipate for an “event.”

He starts talkin’, and the market starts rallying. Volatility begins to decrease as well, since the “unknown” is becoming “known.” The buying is reinforced by dealers who need to “decrease their offsetting hedges.”

Okay, but let’s think about how my trade just morphed. I am betting on movement with the straddle. And look at that, I got it!

With the underlying up 50 handles and volatility decreasing, the straddle looks more and more like a V!

See that red circle…that’s where I am. From there, if the market goes up, the value goes up, but if the market goes down, the value goes down!

That doesn’t look like “betting the over” anymore. I’m actually betting that the market is going to continue to rally!!

My bet is over. I won. If I keep holding, I am taking a new directional bet.

I did not come up with a game plan for that, so I’m out! $2000 winner over a 2hr period.

Oh, and take a look at the rest of the day…That at-the-money straddle (4150 strike at noon CT) was also cheap as hell!

As always, pursue the process NOT the profits!