Comment on Application of Option Greeks

Karthik Rangappa commented on 20 Aug 2014, 06:13 PM

Dear Vaib,

Got your point. I’m going to elaborate a bit for the benefit of other readers..

When you initiate a straddle(both long and short), it is very clear the call is on volatility, and not on the direction of the market. .

When you short the straddle, it implies that you expect volatility to reduce. In other words, you plan to profit from a fall in volatility, and not from a directional movement. Now, in order to fully exploit this point of view, you need to ensure your position is always hedged to directional risk.

When you initiate the position by shorting ATM options, needless to say you are directionally hedged…but when market makes big move, you are no longer delta hedged. Quoting from your own example….

When you initiate the position when mkts are at 7700,

7700 CE delta= -0.5
7700 PE delta = +0.5
Position Delta = 0

However, when the markets falls to 7500 (a 200 point downward drift)..

7700 CE delta = – 0.1 (since its OTM)
7700 PE delta = +0.9 (since its ITM)
Position Delta = +0.8

Notice, with a delta of +0.8, the position is no longer delta neutral…which means along with the risk of volatility, you are also exposed to directional risk.

This also means whenever you initiate a delta neural position, it is neutral at THAT point in time…as and when the markets moves, the delta varies, and hence the position’s delta also varies. The trader has to continuously monitor the position;s delta and ensure they always add up to zero.

You suggested a short gut when markets fall to 7500, lets see how the deltas add up..

Spot = 7500

Short 7700 PE = delta of + 0.9 (as its ITM)
Short 7300 CE = delta of – 0.9 (as its OTM)
Total position delta = 0

(please note, I’ve just approximated the delta’s for ease of explanation)

Clearly, the position is delta neutral…and you can continue doing this, to ensure you are delta neutral. However, there are three things come to my mind..

1) Your costs increase as you pile on more number of trades
2) It would be very hard to terminate the positions anytime before expiry
3) Your estimate on volatility has to be accurate. If the Volatility does not cool off as expected, you may end up making a loss

For something like this to work in your favor, I’d suggest you initiate the position towards the 2nd half of the series. With this..

1) You will benefit from time decay
2) If you are right on volatility,then towards the 2nd half you will have an added advantage of decreasing volatility, and time (see the graph of Vol vs time in the previous article)
3) Premiums will be lower, but so would be the stress on position 🙂

Also, from my experience I can tell you that trades such as these are best done before events such as budget, quarterly results, corporate announcements etc. This is when volatility shoots up, and premiums swell.

Lastly, one of the best ways to play volatility is by initiating trades based on Volatility Arbitrage using dynamic delta hedging technique. I’d suggest you explore this as well.

This turned out to be a post within a post, but as long as it helps 🙂

Good luck.

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