Delta Neutral Trading - Condors etc.

[Fox]

I also like Cottle's approach of breaking the Condor down into a row of butterflies and selling them off as the underlying vists the various apexes.

Mazza, was this from Cottle's earlier books?

The book I have is Options Trading: The Hidden Reality (OTTHR). In OTTHR, he discusses selling off the butterflies in a Pregnant Butterfly (Two-Strike Butterfly). The concept would be similar to selling of butterflies from an IC.

I was just curious which of his books the idea of breaking the IC down was discussed.

 

[cutz]

Mazza, was this from Cottle's earlier books?

The book I have is Options Trading: The Hidden Reality (OTTHR). In OTTHR, he discusses selling off the butterflies in a Pregnant Butterfly (Two-Strike Butterfly). The concept would be similar to selling of butterflies from an IC.

I was just curious which of his books the idea of breaking the IC down was discussed.

Hi guys,

Hope you don't mind me jumping in,

Fox,

It's also in the latest edition, Stretched out Condors, bottom of page 169.

 

[Fox]

From post #39:

I purchase more longs in case the underlying moves to my danger zone, this allows me to close out the shorts and move them closer to the wings with a higher number of contracts, so the backspread turns into a conventional credit spread.

Cutz, I finally understand your post. Took me a while, but the lights finally came on! What a clever idea. I'm going to put this to practice. Could have saved me from numerous disasters in the past, I'm sure.

Mazza, I assume the valley of death is the trough of a backspread (looking at a risk graph), what would be an example of gamma scalping?

How often have you been stuck in the valley of death? Is it common, or rare? Would, say, 1 in 10 rescues result in being in the valley? I'm just curious how often you have experienced this. Also, did you manage to gamma scalp your way out of trouble?

 

[cutz]

How often have you been stuck in the valley of death? Is it common, or rare? Would, say, 1 in 10 rescues result in being in the valley? I'm just curious how often you have experienced this. Also, did you manage to gamma scalp your way out of trouble?

Hi Fox,

Yeah it's happened to me a couple of times one way markets are the worst, the most recent still stuck in my memory was early this week, the big moves caught me out so i just closed the position which was about to expire and set up a fresh one for Oct.

The bit about moving the shorts up towards the wing i've only done once with a spread that was small to start with, in hindsight gradually removing shorts would have achieved better results.

Gamma scalping, i've never attemped it on XJO's as there's no suitable underlying to enable tweeking of the position (IMO), playing with SPI contracts alters the risk profile too much, i'm gradually building a position on the Eurex so we'll see how it goes.

EDIT>>BTW Fox tough question to answer, most of the time what i end up with towards the end of the month is nothing like when the position was set up, ie index moves up, close out short puts, close out some long puts, lay on a fresh set of puts at a higher strike, close out a short call, ect. ect. , this is why most end up overseas markets where the spreads are nicer.

 

[nickleeson88888]

hi guys,

i've got a bit of a dilemma here,

trying to work out a delta for a uni assignment.

we are shorting 1000 calls at $9.63 amd buying delta number of stocks = 880 stocks at $60.69 (delta = 0.88 from the financial review).
we borrow $43,777.20 to pay for the remaining stocks.
that's the portfolio.

aim is to keep the portfolio delta neutral.
if the stock price falls by $0.33 the next day, we have worked out delta to be $0.24242424 (change in call price / change in stock price).

Is this the correct method to work out delta for the portfolio?

and how do we adjust the portfolio to make it delta neutral.

any help would be much appreciated.

thanks!

 

[jackson8]

hi guys,

i've got a bit of a dilemma here,

trying to work out a delta for a uni assignment.

we are shorting 1000 calls at $9.63 amd buying delta number of stocks = 880 stocks at $60.69 (delta = 0.88 from the financial review).
we borrow $43,777.20 to pay for the remaining stocks.
that's the portfolio.

aim is to keep the portfolio delta neutral.
if the stock price falls by $0.33 the next day, we have worked out delta to be $0.24242424 (change in call price / change in stock price).

Is this the correct method to work out delta for the portfolio?

and how do we adjust the portfolio to make it delta neutral.

any help would be much appreciated.

thanks!

hi
in its simplest form if you sell 1 contract with a size of 1000 you would times the delta of the sold strike by 1000. this is how many shares you will need to purchase of the underlyling to be neutral

as the sp rises the delta rises towards 1 in which case you would need to recalculate how many of the underlying you would need to hold. as the sp rises further toward the sold strike price the delta will rise to 1 meaning 1 delta = 1 full share. with the price drop you are able to sell shares to remain delta neutral to achieve the same.

in essence buying or selling quantities of the underlying to remain delta neutral at all times. this can be re-evaluated on a daily / hourly/ weekly basis whichever you choose but obviously is a very commission intensive and costly.
you can also achieve the same by using other options as an instrument to neutralize delta

like i said in its simplest form
Gary

 

[wayneL]

hi guys,

i've got a bit of a dilemma here,

trying to work out a delta for a uni assignment.

we are shorting 1000 calls at $9.63 amd buying delta number of stocks = 880 stocks at $60.69 (delta = 0.88 from the financial review).
we borrow $43,777.20 to pay for the remaining stocks.
that's the portfolio.

aim is to keep the portfolio delta neutral.
if the stock price falls by $0.33 the next day, we have worked out delta to be $0.24242424 (change in call price / change in stock price).

Is this the correct method to work out delta for the portfolio?

and how do we adjust the portfolio to make it delta neutral.

any help would be much appreciated.

thanks!

In any option combo, the "position delta" is simply the sum of all the deltas of each leg.

It's not clear what you have in your position there so I'll go through a worked example.

Long stock always has a delta of 1, Therefore 880 shares has 880 deltas. Stock price is irrelevant.

Short calls have negative deltas so you need some number of call contracts to add up to -880.

A slightly OTM call might have a delta of 0.44 (sold call -0.44) so you would need to sell two contracts to be delta neutral... 2 x 1000 x -0.44 = -880

880 + -880 = 0 Voila! Delta neutral.

If the delta of the options change through stock movement, delta will become unequal. Let's say the stock price moves up and causes the call delta to rise to 0.6

You still have 880 deltas with the stock.

But now you have 2 x 1000 x -0.6 = -1200 deltas with the short calls.

Your position delta is now 880 + -1200 = -320 deltas

To restore delta neutrality you need to get rid of those 320 negative deltas or to acquire another 320 positive deltas from somewhere.

There are any number of ways of doing this, but the easiest way is to buy another 320 shares thereby acquiring those 320 positive deltas. -320 + 320 = 0 and back to delta neutrality.

 

[mazzatelli]

you can also achieve the same by using other options as an instrument to neutralize delta

nick leeson [he was my hero too :]
If you are focused primarily on neutralising delta, then use spot.

Using options introduces other Greeks [vega, gamma, theta, rho] as well as delta, and depending on strikes and expiry changes the nature of replication. If I remember my uni assignment, it would be focusing solely on an options portfolio + dynamic hedging with spot.

Good luck with your assignment

 

[nickleeson88888]

thanks for the help guys. just want to clarify my question a bit, but first the assignment asks:

1.to identify an option you believe is mispriced.
2.develop an arbitrage, delta-neutral strategy that will make money from the mispriced derivative. detail minimum costs, and you can use as much money as you like because it's theoretically risk free and none will be lost anyway.
3.then we are responsible for adjusting the delta-neutral portfolio (for two adjustments) while recording transactions and profit/losses.




We picked RioTinto's option at random because, technically all options are mispriced. But of course we show B-S calculations indicating it's underpriced.

To make an arbitrage strategy, first we sold (because B-S model indicates it's underpriced) 1 call contract, and consequently purchased shares. the delta was 0.88 (obtained from the financial review)

(feel free to correct me if i've made mistakes along the process)

So we are shorting 1000 calls at $9.63 and buying delta number of stocks = 880 stocks at $60.69 (delta = 0.88 from the financial review).
we borrow $43,777.20 to pay for the remaining stocks.
that's our portfolio to begin with.

problem is, i'm unsure how to "maintain" delta-neutrality. is it fine to use the delta from the next days financial review?



also, when they say "close-out early", how can it be advantageous to close-out early?

thanks!

 

[mazzatelli]

We picked RioTinto's option at random because, technically all options are mispriced. But of course we show B-S calculations indicating it's underpriced.

Ugh.
"Technically" they're mispriced because BSM assumptions don't hold [lognormal price density, geometric brownian motion, constant vol], but these shortcomings are adjusted via implied vols, typified by strike and tenor vol skew.

If an option is underpriced, you would BUY it and delta hedge. Implicitly this means you expect future realized vol to be higher than the present option iv.

w.r.t maintaining delta neutrality, for assignment purposes, you can choose to rebalance 1) every day or 2) when total portfolio delta accumulates to an amount you are uncomfortable with [e.g. rebalance every 500 deltas]

Close out early, if you believe your target has been reached [i.e. what you think the option price should be] so that you are not exposed to further adverse moves in the market that will require hedging.

Caution though, it is Friday arvo and I've downed a few cheeky beverages

 

[wayneL]

Nick,

I'm interested in how the undervaluation was determined.

If it was an individual call that was underpriced relative to the rest of the chain, and in particular in relation to its corresponding put (which I doubt in these days of lightning fast arbitrage super computers), the correct risk free strategy is a "reversal". A short call/long stock combo is not risk free in any sense of the term and is not an arbitrage strategy.

A reversal consists of purchasing the underpriced call, selling the corresponding put and shorting the stock in equal size. This creates a risk free arbitrage position that never needs further hedging.

Wind up the strategy when put/call parity is restored.

 

[mazzatelli]

Actually Wayne is spot on

But if I remember right, that is beyond 1st yr derivatives for uni though. Back in my day we were asked to do the option + stock portfolio as building blocks to understand risk neutral valuation for binomial pricing.

Looking at nicks point 3) of the assignment, that might be the case. I missed the part about arbitrage lol

 

[wayneL]

Looking at nicks point 3) of the assignment, that might be the case. I missed the part about arbitrage lol

Yep

The question is actually quite flawed in that sense.

It's asking for a risk free arb, that must have risk if it is necessary to be dynamically hedged.

 

[nickleeson88888]

right you are maz. we're now using volatility to identify if the call is mispriced. that is by analysing historical volatility and seeing whether current volatility is significantly different. we'll use historical prices to calculate the 'correct' volatility and if it's lower than implied volatility, then that must mean it's underpriced.

but for calculating delta N(d1), is it better to use the historical vol or implied vol?

what risk free rate would the financial review use? unsure about which one to use for this assignment. considering using the 30 day bank bill swap ref rate.
all this will affect our theoretical call price from BSM.

and where is the profit meant to come from exactly? the fact that it's not perfectly hedged? hard to get my head around this bit.

 

[nickleeson88888]

one more thing,
how do you get the same call price & volatility for like several consecutive days when the financial review only states those traded above 5k and some days the option quoted from the previous day is no longer stated?

 

[wayneL]

right you are maz. we're now using volatility to identify if the call is mispriced. that is by analysing historical volatility and seeing whether current volatility is significantly different. we'll use historical prices to calculate the 'correct' volatility and if it's lower than implied volatility, then that must mean it's underpriced.

Nick

Of course you have to follow your course to get your degree, but in the real world, there is no definitive way of calculating over/undervaluation of options using historical volatility.

1/ What we really need to calculate this is forward volatiltiy for the life of the strategy. Unfortunately this is in the future so cannot be known. That forward realized volatility can vary significantly from the current calculated volatility.

2/ The HV figure you end up with can be highly dependent on the lookback period. 20,30,60/whatever day volatilty can all be significantly different to each other.

3/ Hence "Implied Volatility" via the current tradeable price. This is the market's forecast of forward volatility. Whether this is too high or too low is highly subjective and can only be definitively determined in retrospect.

4/ The last traded price in the "Fin" is a very poor representation of the current tradeable price and cannot be sensibly used in the real world as that last traded price may be several hours old. If the market has moved on considerably, the price quoted will be a furphy. Better to use current bid/ask if you can get it.

but for calculating delta N(d1), is it better to use the historical vol or implied vol?

Implied, as this is the basis for the option price.

what risk free rate would the financial review use? unsure about which one to use for this assignment. considering using the 30 day bank bill swap ref rate.
all this will affect our theoretical call price from BSM.

Not sure on this one in the Oz market. In the US market the 3 month treasury bill is used.

and where is the profit meant to come from exactly? the fact that it's not perfectly hedged? hard to get my head around this bit.

If you are short gamma (long stock/short calls) you profit if theta decay and/or drops in volatility are greater that hedging losses and contest risk (commision + spread) of the hedging transactions.

If you are long gamma (short stock/long calls) profit is derived if volatility rises and profit locked in from the delta hedges are greater than losses from if vol falls and theta decay.

This is a topic all by itself that needs more than a few lines to explain properly.

 

[nickleeson88888]

cheers wayneL. all valid points indeed.
are you able to tell me if it's possible to obtain a particular options price on a daily basis and its implied vol?

i've got my eyes set on WOW call options expiring on dec 2011 with a strike price of $34.00.
the day i picked this option, obviously it was in the Fin but the next day it's not so i'm wondering if there are any sources that provide historical data for aussie options? (not requiring a cost of course)

if not, can anyone with access to historical options prices post WOWs on here or PM me?
thought i'd ask for that one just in case :

if you can then i'll let you know what time period, it's not a long one

 

[wayneL]

Nick,

I don't trade Oz options so can't help. Getting free info is often problematic in Oz, but hopefully someone has some resources for you.

If it was US options, there are a multitude of free resources.

 

[cutz]

Hi Nick,

Not much action on those, WOWRU7 have an open interest of 7.

Try here http://www.morrisonsecurities.com/int_trading.htm for a webiress demo, it's got what you need, look in the options monitor window to get the quotes, course of sales for history, bring up a chart window and punch in WOWIV for an IV chart.

 

[nickleeson88888]

In current market conditions, does it matter which 2 other Greeks are better to hedge against including delta? that is 3 Greeks in total. For example you should hedge against Rho in the current market if you think interest rates are going to change.
Any suggestions?