Neutralize Extreme Volatility Shakeouts
by Jeff Coglianese, Senior Broker & CTA
January 7, 2005
Neutralize Extreme Volatility "Shakeouts" With Option Trading: Learn How to Stay in the Market and Potentially Profit When Others Are Stopped Out
Volatile Times, Volatile Markets
As we reflect on the past year, we recognize that there was one constant throughout most futures markets: price volatility. This volatility was witnessed in stock indexes, precious metals, interest rate futures, currencies, grains, oilseeds, livestock, softs, and especially energy markets. Last year we witnessed war, terrorism, a Presidential Election, an explosion in deficit spending and natural disasters, all of which impacted one or more of the above market groups. The new year is upon us, and many of these markets still offer the promise of continued price volatility. Many of the same factors remain in place, such as the ongoing war in Iraq, the threat of terrorism, growing budget deficits and new natural disasters.
The Frequency of Sharp Counter-Trend Moves
If we look at markets that make large moves in one direction, we often see sharp counter trend moves. These moves are often sharper and faster than the original trend move, i.e. gold futures rally $30 per contract over 10 sessions and then fall $15 in one session, often decimating flat-price futures positions in the process. In this example, longs are shaken out and the trend may continue. If we look at charts of markets that exhibited bullish trends, we see that this type of volatile counter trend action is frequent.
Insulate Yourself form Sharp Corrections with Delta Neutral Trading
Trending markets that may be subject to sharp corrections lend themselves well to price or "Delta neutral" type trades. This article is intended to be an introduction to Delta neutral trading with futures options. There are numerous types of Delta neutral trading; the focus of this article will be the use of long straddle positions. These trades are defined risk (i.e. the maximum risk is known at trade initiation). It is assumed that the reader has an intermediate-level familiarity of options. If you have any questions regarding option basics, I will be happy to recommend several introductory readings.
Meet "The Greeks"
This article will frequently refer to the option sensitivities Delta, Gamma, Vega and Theta. These sensitivities are known as "Greeks" because they are named for letters in the Greek alphabet. While Vega is not a Greek letter, it is used by traders to refer to an option's sensitivity to changes in implied volatility. In most academic texts, Kappa is used instead of Vega. For this article, we will use Vega.
Delta refers to an option's rate of change in relation to a move in the underlying futures contract. Delta is a percentage. However, in practice, the decimal point is dropped. For this paper we will not use the decimal. If a call option has a Delta of 50 (50%), then a 1.00 move in the futures contract would equate to a .50 change in the call price, everything else remaining constant.
Gamma measures the rate of change in Delta for a move in the underlying future. Gamma, in other words, is the Delta of the Delta. For example, if our call option has a Delta of 50 and a Gamma of .05, then a 1 point move up in the underlying future will increase our Delta to 55, everything else remaining constant.
Vega, as mentioned above, measures an option's sensitivity to a change in implied volatility. A Vega of .10 would indicate that for a 1% change in implied volatility (from 12% to 13%), the price of the option would change by .10. To illustrate, if a call with a price of 1.00 and a Vega of .10 were to experience a 1% increase in implied volatility, we would expect the price to move to 1.10, everything else remaining constant.
Theta measures the effect of time decay on options. A Theta of .01 would indicate that the option would lose 1% of its value per day. Theta is not linear and increases as we move closer to expiration. For example, we would expect a call with a price of 2.00 and a Theta of .01 to lose .02 a day in the near term, everything else remaining constant.
What does it mean to be Delta Neutral?
Delta Neutral, by definition, is simply a mathematical condition in which an option position has no bias on price direction. This condition normally only applies to the first few ticks of the underlying vehicle. For example, a trader is long a 100 straddle (call and put at the same strike price) with the underlying future at 100. The call will have a Delta of +50 while the put will have a Delta of -50. If we add these Deltas together we have a net Delta of zero, hence the term Delta neutral. As the market moves higher the call Delta increases while the put Delta decreases. We become longer in Delta terms as the market moves higher. To illustrate, we will assume the underlying future has moved to 102. With the market at 102 our long call has a Delta of +52 while our long put has a Delta of -48. Our position has a net Delta of 4 (+52 + (-48) = +4) or in other words we are long 4% of an underlying contract.
The single straddle example above is a simple two-contract position. If we make the original position long 25 straddles, a move in the underlying up to 102 creates a position Delta of +100 ((25 calls * +52) + (25 puts * -48) = 100). This is the equivalent of being long one underlying contract. If the trader wishes to remain Delta neutral, one of the choices he has is to sell one underlying contract at 102 to return the position to neutrality ((25 calls * +52) + (25 puts * -48) + (1 short underlying -100) = 0).
If the underlying market moves back to 100, our position now will have a Delta of -100 ((25 calls * +50) + (25 puts * -50) + (1 short underlying -100) = -100). Again, if the trader wishes to be Delta neutral, he can buy back the future at 100 and return to neutrality. The trader now has their original position plus a profit of 2 on the underlying contract trade. If the Theta (time decay) of the straddle position, along with any transaction costs on the underlying contract, is less than 2, the trader has made money, assuming no change in implied volatility. This type of Delta neutral trading is often referred to as Delta hedging, Gamma scalping or "trading the tail."
The basic idea behind this trade is that as a market moves in a direction, your position becomes biased in that direction. As the underlying market moves up, your position becomes long. Eventually if the market kept rallying, each of your long call positions would be equal to a futures contract. If the trader has a multiple contract position, adjustments can be made by selling futures when the Delta of the position gets to large. Each adjustment locks in a portion of the underlying's move, reducing the risk of the position. Stated quite simply, more price volatility = more Delta adjustments = better trade performance.
2004 Delta Neutral Trading Strategy Examples
In trading, timing is everything. If we look at several markets that had some of the largest moves in 2004, these moves were not straight up or down. In each case, the market experienced a sharp counter trend move that forced any prudent speculator to the sideline. A Delta neutral strategy would allow the trader make adjustments based on volatility and eventually have a position that is biased in the direction of the trend.
Crude Oil Futures
If we look at January 2005 Crude Oil futures (Exhibit 1) from August 1, 2004 until the end of October 2004, we see a great example of a market making a big directional trade with extreme counter trend movement. If a trader bought January crude futures on a close above $45 per barrel looking for a rally to $50, he would have been a buyer at $46.01 on August 20, 2004. He would then have had to sit through a $5.15 drawdown over the next 6 trading sessions before crude oil eventually made its move to over $55 at the end of October. A Delta neutral trader who bought the $46 straddle had a $5 drop to adjust by buying futures and then a $14 rally to sell futures against. The idea is that a Delta Neutral trader welcomed the $5 counter trend move, while the long futures trader was likely stopped out, or at least had a very uncomfortable week of trading.
Crude Oil Futures Chart
Another example from 2004 is Copper (Exhibit 2). The December copper futures in August closed above $1.30, signaling a breakout. Chinese demand and a strong US housing market made $1.50 a realistic target. A trader who bought futures on August 13, 2004, when the market closed above $1.30, had to sit through an 8 cent sell off over the next 8 sessions. This was followed by a 26 cent rally to $1.48. Three sessions after hitting $1.48, copper futures fell 21 cents before rallying back to $1.46 at the end of November, 2004. A Delta neutral trader who bought the $1.30 straddle had an 8 cent drop to adjust by buying futures and then a 26 cent rally to sell futures against. Again, the idea is that a Delta Neutral trader welcomed the 8 cent counter trend move, while the long futures trader was likely stopped out.
Copper Futures Chart
If we look at soybeans in 2004 (Exhibit 3), we see that we were coming off one of the biggest bull markets in history. Tight US supplies had propelled soybeans over $10.00 per bushel for only the third time in history. A futures trader may have looked to sell futures on August 4, 2004 as the market made new lows. The weather looked good for the soybean crop, and the chart looked negative. A trader who sold the close of $5.57 had to sit through a $.94 rally before prices eventually headed down to a low of $5.01. A Delta neutral trader who bought the $5.60 straddle had a $.94 rally to adjust by selling futures and then a $1.50 sell off to buy futures against. Once again, the idea is that a Delta Neutral trader welcomed the $.94 counter trend move, while the short futures trader had a $4700 draw down per contract before the market finally broke to the $5.01 low.
Soybean Futures Chart
Hopefully the examples above clearly show the benefit of trading long straddle Delta neutral positions in uncertain and volatile times. The risk in a Delta neutral straddle trade is that the market does not move enough to offset the effects of time decay.
However, limited risk upon trade inception, in combination with a progressive directional bias if/when volatility increases, can enable a trader to endure and perhaps profit from moves that often shake others out of the market. In contrast, outright futures positions can devastate a trader during an extreme market period, even if they are eventually proven correct in the long term.
To learn more about Jeff Coglianese, visit his broker bio here.
View Additional Articles Written by Jeff Coglianese:
- How to Use Options in a Volatile Market Climate
- Using Spreads to Sell Option Premium
- Why Trade Option Spreads?
- Is Option Selling the "Write" Strategy for You?
- Forget What You Thought You Knew About Buying Options: Strategies That You Probably Haven’t Heard Before
- Developing a Trading Strategy & System
- Why Do Traders Lose?
Options Risk Disclosure: An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price. Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different. For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option. Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options). Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised. The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero. Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received). The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.