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WhoTrades Live: Taking Advantage of Aggressive Put Buying in Financials

WhoTrades Live is an investment platform that puts you in charge of what traders and portfolios you invest in across a host of various strategies.

On WhoTrades Live you can find thousands of these portfolios and traders by filtering by portfolio yield, trades count, drawdown, and performance history. 

Today we’re going to talk about delta hedging.

Having a delta-neutral position – or even delta-hedged portfolio more broadly – is a fairly well-known strategy, as it’s integrated within the equity market. It’s an options strategy that involves being approximately price-neutral to a market.

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Delta Hedging

On Tuesday, December 4 and Thursday, December 6, there was very aggressive buying of puts on financial and bank stocks, particularly in the December 14 expiries.

A lot of this had to do with the headlines about inversions in certain parts of the US Treasury curve. Banks are also pro-cyclical and Tuesday and Thursday saw a material sell-off in equities, which may incentivize traders to hedge their holdings most heavily tied to the business cycle. Banks are also the first to report earnings starting tomorrow/this Friday, so there are new data points coming out that could drive their prices. Naturally traders will target near-term expiries to take advantage of this because it gives them the greatest opportunity to make money. A confluence of these factors led to aggressive buying in this area of the market. 

All this demand presents opportunities for sellers. When you sell short-term options you will win most of the time and make money on net for the simple reason that traders typically overpay for them. This is because they perceive an opportunity to make a lot of money in a short period of time based on a specific catalyst. But most of the time, they not only pay too much for implied volatility relative to future realized volatility, given a net edge to the seller.

For the seller, because writing options has unlimited downside, you need to (or should) delta hedge that position to help offset the price risk.

If you wanted to take advantage of this theme, you could target the best deals in specific bank securities (e.g., those with earnings coming up) or you could simply go with an ETF like XLF.

For the sake of providing a concrete example, I’ll go through XLF.

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Example

(Note that these numbers constantly change.)

Going off just one contract:

Sell: 1 XLF 26 Dec 14 ’18 Put @ $50 per contract (Delta = -.515)

Short: -.515 * 100 = -52 XLF shares (rounded)

Note: How many shares to buy or short-sell is based on the formula of the number of options contracts bought or sold multiplied by the delta multiplied by the number of shares per options contract (100).

Margin requirements

Puts: Likely $500-$600 per contract

Stock: 52 shares * $26/share = $1,352 (for cash account); $676 (Reg-T); Lower for portfolio margin (depends on what else is in your portfolio since it penalizes for concentrated risk exposure)

So if this trade were to pertain to a Reg-T account, your expected return would be around 4%, or the $50 in premium divided by the total margin requirements (slightly above $1,200). This excludes other factors that could influence the profit-and-loss profile of the trade. Accordingly, there’s a wide standard deviation around the return estimate.

And just to be clear, delta-hedging is not in any way a risk-free way to profit from the market. It is simply designed to hedge against price movements, and options are valued off more than just price alone.

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What is delta and how do you hedge it?

The delta of an option refers to the change in the price of an option relative to the change in price of the underlying security. For long calls, delta is always between 0.0 and 1.0. For long puts, it is always between 0.0 and -1.0.  

A delta of 0.515 means you would buy or short-sell 51 or 52 shares per contract, depending on the type of option and how you round.

If you buy a call option with a delta of 0.515 and want to eliminate your price risk, you would short-sell 52 shares, rounding up, of the underlying (since there are 100 shares per options contract).

If you sell a call option with the same delta, you would buy 52 shares.

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Risks

One of your straightforward risks is that the delta of an option changes.

The more in-the-money an option is, the closer the delta will be toward 1. For out-of-the-money options, the closer the delta will be to 0. For at-the-money options, delta will approximate 0.5. That means if your options changes from ITM to OTM, or vice versa, your delta can change dramatically to the point where you’re no longer hedged at all against price movements.

You risk losing money on delta hedged trades because of changes in volatility, time decay, and changes in interest rates – or, in terms of other first-order Greeks, to changes in vega, theta, and rho, respectively.

Of course, you can always adjust the position to ensure that it is delta-hedged at all times, but the transactional costs and any illiquidity in the options market will eat into the profitability of the strategy.

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Gamma Hedging

Gamma is the change in delta relative to the change in the price of the underlying. In other words, it’s the second derivative of the change in an option’s price relative to the change in the underlying.

Gamma is highest when an option is at-the-money and lowest the further in-the-money or out-of-the-money it is. 

When you sell options, you are short gamma (usually), and long gamma when you buy them (usually).

Gamma should also ideally be hedged so the performance profile of the trade is more stable over a variety of outcomes.  

Gamma hedging could take the form of buying a long put at a strike price different from the one cited in the example – or a series of them while also keeping in line with the price neutrality goals of the strategy. This would help offset some of the risk associated with a substantive move in the underlying delta.

Nonetheless, gamma adjustments to a portfolio are an entirely different topic on their own and a subject for a future post.

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Summary

Delta hedging entails removing the directional bias from your portfolio.

Taking advantage of this potential source of return is one further way to diversify your returns streams and in an uncorrelated way. When you combine uncorrelated sources of return you increase your reward without increasing your risk, a concept expounded on in previous posts.                                                                                                     

Many traders on WhoTrades Live integrate options into their portfolios.

This trader uses options within the context of a portfolio that has returned 32.6% over the past year: 

(Source: Portfolio Page)

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This portfolio is also in the green this year, up 8%, and has most of its exposures in options: 

(Source: Portfolio Page)

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The following portfolio is unique because a) it exclusively uses options, b) it is uniformly bearish, and c) it is very concentrated.

72% of the portfolio is bearish on Amazon ( $AMZN ), while 28% of it expresses a bearish position on Tesla ( $TSLA ). 

(Source: Portfolio Page)

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As a whole, WhoTrades Live provides thousands of portfolios that you can view, follow, copy, and learn from. It allows you to invest on your own without being alone in the process and without the large costs associated with outsourcing managing your savings to expensive financial advisors and actively managed products.