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- Offsetting Exposure
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!
Quote of the day:
"The enemy of my enemy is my friend"
- Ancient Proverb
If you are trying to stay market neutral, you despise directional exposure! And come to think of it, directional exposure also despises opposite directional exposure!
Ipso facto, if our positions end up getting exposure to one direction, we want to become very good friends with exposure in the opposite direction!
In order to understand dealer hedging implications from open interest, we first must breakdown the mechanics of reducing directional exposure of a call or a put.
BANG for Your Buck:
| 1/19/2023 SPX = 3928.86 | Handles of Movement | 1-Day Implied % Move |
|---|---|---|
| BANG (intraday) | 50 | 1.3% |
| BANG (weekly) | 111 | 2.8% |
What a nice little session yesterday!
Market rallied 20 handles on the open (above the large option positioning level 4000 we've been mentioning all week)
Then turns down 30 handles. (oscillation around 4000 looking primo so far!)
So, the market banked 50 handles of movement by 10AM and, if option volatility doesn't elevate, it's looking like it's going to toy with that 4000 level again.
But after it failed to turn back up, option volatility (expressed at the bottom of the chart with the VIX) immediately started to elevate.
This is exactly what you need to see in order to extend outside the implied movement via the option market
Look at the red line, that's basically an entire new trading day!
What was the catalyst?
Look at the list below and feel free to point to any one of 'em! But, you shouldn't even care!
All you need to know is: the option market had to reprice expectations after 10a. You can then discount the prior oscillation theory and start trading the "new" session!
For all you Bayesian statisticians out there, you always have to update your priors!
Things to look for this week
Large shorter term option positioning at 4000 level in SPX
This creates larger impacts on dealers' (bookies) need to reposition in order to remain market neutral (also known as hedging)
Dealers seem to be net long the calls around here, meaning as the market rallies above 4000, they need to sell SPX underlying. As the market sells off below 4000, they need to buy SPX underlying
4000 level is still in play as a "pin-able" level for Friday's option's expiration.
VIX < 20 & implied volatility via options is less than realized volatility via underlying movement.
This has generally marked a short-term topping process, and the expectation of a move lower
VIX has now inched over 20 and the market has come off a touch. Thanks for the layup, option market!
Reports / News
Couple of Federal Reserve talking heads spewing rhetoric
Paraphrasing: "F*ck your puts, f*ck your calls, JPow has you by the ballz!"
Retail Sales
Report: Not good. consumer spending is slowing, even though "inflation is cooling"...suuuuuurrrrreee
Manufacturing numbers
Report: Empire State manufacturing worse than expected
Effect: Nothing material ~ 15 handles of movement
Bank of Japan
Did what was expected. They will continue to sell their US treasuries in order to buy their own bonds and defend the strength of the Yen
Homebuilders, building permits, building starts, and jobless claims
Report: came in higher than expected but still bad in absolute terms
Ex: KB Homes reported a 68% cancel rate on new home builds. Compare to prior year at 13%. So, a bunch of people don't want to build what they contracted to do less than a year ago!
Bunch of Q4 earnings reports
Not good either
"We are preparing for economic slowdown" / "layoffs are starting" type comments on earnings calls
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 I buy a call
In simple terms, as the market goes up, the likelihood of my call ending up in the money goes up, therefore the value of the call goes up. Woohoo!
But, how much does my call value increase?
Good question, young Padawan!
You just discovered Delta: The change in the option's value with respect to the change in the underlying price.
For anyone who remembers Calc 1, it's the slope of the blue curve.
The best it can do is become the underlying and then its value will change 1 to 1 with the underlying price (remember, options are derivatives...and unlike what some people believe lately, mathematical terms actually mean something!!)
At most points on that blue curve, the value of the call will only increase/decrease by a percentage of what the underlying does. Hencethereforce, the delta of an option is rangebound from 0.00 to 1.00.
Let's get rid of that directional exposure!
Imagine the underlying price is right at that red X. The slope of the blue line at that point is what we want to get rid off, correct?
No problemo! It looks like we have directional exposure to the upside, so I'll do the equal and opposite to that purple line.
What if I place an offsetting bet to my original call bet, which is represented in the orange line. In this case, I will sell the exact percentage of the underlying I need to based on the slope of the purple line (the delta).
Example: I have 10 call options on. The delta at the red X is +0.30. So, in order for my delta to be 0 at the red X (i.e. market neutral), I need to sell 0.30 *10 = 3 underlying contracts.
Let's add the blue and the orange line together...goddammit, drawing is tricky in mspaint!
The green curve is now my call option combined with my offsetting hedge.
The green curve is nearly flat at the red X and then starts sloping up as your move away from it (sneak peak: this why dealer hedging is predictable!)
Notice: the directional hedge works best near the red X. This is because the call's directional exposure does not change linearly!
Also, for you option hot shots out there, that green curve should look familiar. And think about what that graph shows, you forgo some of your original call profits as the market rallies, but you add potential profits even if the market breaks...kinda cool but start thinking about the pitfalls!
This is just one way to explain delta, and don't worry if it doesn't click yet. We will have an entire week dedicated to figuring out each basic "greek" using a variety of visualization and analogs.
Tomorrow, we'll stitch together basic call put hedging and open interest to reveal tiny black holes in the market! Stay tuned!