Yuriy Ukazkin
Stock exchange news, options. Actually, such tactics may be called anyhow, but its principle always remains the same – forming a delta-neutral structure from basic asset and options. In money terms option delta is known to amount to 0.5, which means that 10 options are needed for 5 contracts of basic asset in order to be neutral to the market.
Supposing, we have formed such structure. What to do next?
Next, as explained by Commodity Trading Department of , one is to trade the base the way he knows, but remembering to follow the rule of “being neutral to the market”. This is explained in detail in the course “Options: from Beginner to Professional”, but we would like to show pure mathematics of strategy’s efficiency when all rehedging rules are followed.
Let us take XDE as an example, which is a currency ETF traded at Philadelphia stock exchange. Supposing, we have opened position 2.03, as shown on the picture below. Horizontal lines show delta points 0.4, 0.5, and 0.6. As we can see, for 2 weeks the price has been ranging between delta points 0.4 and 0.6; futures trade was held at these points or close to them. Option tetha 59 to expiration is 0.02, which means about 2 dollars per day; we have chosen this range because of its optimum balance of tetha, vega, and gamma (last coefficient is of major importance, as it defines the price increment of rehedging; more distant options have smaller tetha and larger rehedging increment, which is not very convenient to us). This, as shown on the picture, we have performed 8 rehedging transactions with future, 4 of them involved profit taking. The total profit from rehedges has amounted to 575 points, tetha loss has amounted 36 points, commission loss has amounted 7 dollars per option and 40 dollars per basic asset. Consequently, our 2-week profit has amounted to 492 points.
However, one is to consider possible loss from lowering volatility in the formula of break-even point (in our case volatility has risen, but it could have declined too). Current volatility amounts to 8.5% and is close to annual minimum, which gives another hope for fewer risks. Nevertheless, let us count how much profit is lost when volatility declines by 0.5% (to annual minimum) and by 1%.
And there is the trouble!!! Option vega is 0.2; in other words, when volatility drops by 1%, option loses 20 dollars of its cost. So, if we have 10 options in the structure, this means that when implied volatility drops by 0.5%, we lose 100 dollars, and if it drops by 1% – 200 dollars.
The profit from using the strategy amounts to 492 dollars; even if volatility drops by 1% (this is a lot for the tool), we have 292 dollars. Consequently, we have calculated the break-even point of the strategy and may confirm that it should be opened only in view of rising volatility; otherwise, there is a risk of loss. However, wise tactics of basic asset rehedging may outweigh the risk of falling volatility, time value decay, and expenditures.
Yuriy Ukazkin
