Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
GAMMA SCALPING A VERTICAL?
What do you think about hedging directional risk of a vertical spread with stock?
That’s an interesting question, but one without a “one size fits all” answer. Hedging delta risk and possibly taking advantage of this position type’s potential long gamma rests with the trader’s objective, risk tolerance, and whether he or she maintains account restrictions regarding this type of hedge and net positioning.
When a trader has some type of vertical on, the position is already hedged to a large extent by the other short or long contract. Depending on how close the position is to the underlying, time remaining, strike distance, and volatility, the hedge may be more or less effective than it had been prior to when the position was established. Nonetheless, the vertical spread does afford the trader a net contract—neutral position.
Anytime stock is considered for hedging or offsetting deltas of such a position, the trader needs to be aware that the contained risk of the vertical has been canceled. Remember, 100 shares of short stock is the equivalent of a short call/long put position. Thus, the net-neutral contract count of the vertical will be compromised when stock is involved, no matter how small the risk is determined to be by the trader.
Keeping that in mind, the trader might consider buying in the short contract if it’s not too costly and then proceed with using stock as a hedge for the existing long contract’s deltas and make use of the position’s long gamma or curvature. By making this adjustment, the trader would be moving from a vertical into some form of a synthetic straddle or synthetic long call or long put equivalent.
An alternative hedge that most traders can execute without restrictions or worries of open-ended risk would be to establish an offsetting vertical against the existing vertical position. The combination of such an adjustment establishes a long condor or long butterfly that is either all calls or all puts.
SKEWED THINKING?
Many large-cap equities have the call options skewed so the at-the-money and out-of-the-money trade cheap compared to those calls that are in-the-money. What’s behind this pricing? I like the idea of using a bull call spread in many situations where I’m bullish, but I hate the idea of giving away the theoretical edge when forced to “buy high” with the lower purchased strike and “sell low” with the short contract.
What you’re encountering isn’t the natural order of the universe but it’s close, as pricing phenomenon in options relates to many issues, particularly larger capitalization. On the whole, institutional customers are buyers of stock and primarily maintain a long bias in the market. Particularly after a favorable move, those traders often use the sale of at-the-money and out-of-money calls to hedge and reduce position risk.
By virtue of this type of customer coming into the marketplace as a seller of these calls, the “other side,” typically market makers responsible for providing fair and orderly markets, will demand better prices for buying additional and sometimes near-perpetual amounts of calls. This is particularly true if little other order flow is available to offset the increased vega risk collected on the higher strikes being acquired.
As for the dilemma of buying higher implied volatility associated with the lower strike call while selling cheaper implieds on the short call, don’t be overly concerned. The more important consideration is simply to make sure the call sold takes in enough premium to make the position attractive versus simply purchasing the long call.
Remember, too, upon exiting, if you’re selling the spread to close, the same skew that made you hesitate may still exist. In effect, when closing out the spread, the round trip would result in something of a wash as it relates to any worries regarding the skew when opening the trade.
OPEN AND INTERESTED
I recently purchased several long call contracts in Riverbed Technology (Rvbd). As the only trade in this particular option that day, I was confused when the open interest remained the same the next session. Why didn’t it move?
What you’ve encountered is a situation where your buy order “to open” has been offset by a seller closing out his or her position. A perfectly matched-up order like this won’t affect open interest as one party exits, but whose spot is filled by the fresh opening position.
Realize that open interest merely reflects net open option contracts. Thus, while two parties are involved in every trade, the open interest statistic only increases or decreases when both sides are opening or closing.
To illustrate, if open interest in a call option were zero, and one day, a single print of 100 calls was posted, the next session’s open interest would increase to 100 contracts to reflect both the opening buyer and opening seller.
Now say a short time later, with open interest unchanged at 100, the buyer decides to exit his or her lot by selling to close. If it so happens that the original opening seller was a market maker and once more is the sole liquidity provider at work, the purchase will be 100% closing. That trade would result in taking open interest of 100 contracts back down to zero.
If on the other hand there happened to be a resting book order to buy 50 of the calls (to open) at the price the trader is willing to sell at, then we’d have a situation where open interest would be reduced down to 50 contracts.
Contributing analysis by senior Optionetics strategist Chris Tyler.