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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:
"Bad boys, bad boys, whatcha gonna do, whatcha gonna do when they come for you"
- Bob Marley via COPS theme song
Doesn't it make perfect sense that Bob Marley understands how dealers think?!
Well, I guess he probably didn't know his Bad Boys song would become a theme song for the TV show COPS, which also serves as a mnemonic trick to remember how option dealers hedge...
Nevertheless, Calls Opposite Puts Same (COPS)!
A few days ago, we covered a typical long call hedge. The gist was "if you're long a call, you sell some underlying." (your hedge is opposite to what your option position is)
Today, we'll look at how hedging a short put works. We are specifically looking at a short put because it is typically what a dealer's position is. (e.g. most people are long stocks and want to protect their downside, hence people like buying puts from dealers)
Using COPS, you already know the answer! If you're short a put, you also must short the underlying to remove directional exposure.
Also, you may want to jam out to this banger to get your day started!
As a reminder, long call and short put hedging will help you understand the implications of dealer hedging from open interest. But even better, it will help you understand volatility trading!
BANG for Your Buck:
| 1/24/2023 SPX = 4019.81 | Handles of Movement | Implied % Move |
|---|---|---|
| BANG (intraday) | 50 | 1.2% |
| BANG (weekly) | 110 | 2.7% |
Position Note: Dealers are net short the 3900 strike. A break below opens the door for expanded volatility and easier extension of a selloff. (this should make more sense after you read the end of this newsletter)
As a reminder, the BANG tells you what the option bookmakers are pricing potential underlying movement. As BANG expands (expected volatility in the market), bookmakers are pricing in larger potential underlying movements. And in the context of hedging, they are pricing in a greater need to hedge themselves.
This is why the BANG is extremely important. We get insights from the ecosystem that supports massive option bets, not necessarily that some gambler bet big on a direction.
Reducing an Option's Directional Exposure
Call = A contract between a buyer and a seller that gives the buyer the right, but not the obligation, to purchase the underlying asset at the predetermined price (strike price)
Put = A contract between a buyer and a seller that gives the buyer the right, but not the obligation, to sell the underlying asset at the predetermined price (strike price)
Let's say you sell a put
All those "rights" that the buyer of an option gets...yeah, you're the jabroni that has to fulfill those!
Specifically for selling a put, you now have the obligation to buy the underlying at the contract strike price, if the put buyer so choses to exercise.
Remember, as the market goes down, the put value goes up. So as the seller, you capped your max profit and opened yourself up to unlimited losses...good job, ya masochist!
Think about your Profit and Loss
Instead of going over delta as the first derivative of price with respect to underlying movement, as we did with the long call, just think instinctively.
Selling a put is betting that the market does not close below your strike price on expiration.
Since we sold it, we want the value of the put to go down. You probably heard the age-old trading adage buy low, sell high...well, turns out it's not path-dependent so, you can also sell high and buy low!
Let's just think about our risk: if the market goes down...you're f*cked i.e. the likelihood of your put ending up in-the-money goes up, therefore the value of the put goes up...and you're the genius who sold it a much lower price. Ouch!
How do you prevent yourself from losing money if the market goes down?
Why not just sell the underlying too! Bingo bango...Puts Same... your "short put" losses will then be offset by your "short underlying" gains!
What if the market keeps going down?
Keep selling more underlying, goddammit!! And do it fast because your "short put" is losing money faster than your "short underlying" hedge is gaining!
What if the market rallies?
Almost forgot about that...you make a little money on your "short put" and lose money on your "short underlying". And since you don't need as much of a hedge anymore, you then buy back your short underlying...at a higher price...so you literally just sold low and bought higher. whoopsies.
Congratulations, you just entered the world of hedging negative gamma!
So as the market goes lower, you need to sell more underlying, and also if the market goes higher, you need to buy more underlying. I don't know about you, but this sounds like it adds volatility of the underlying market.
For you option hot shots out there, start thinking about why calls or puts doesn't matter for directionally hedged positions...it only matters if you are long or short the option.
Tomorrow, we'll dive more into dealer hedging of short option positions and why that exacerbates underlying moves and increases volatility.