Friday Option Quiz - Issue #3

What to do when vol is up but stocks go nowhere?

Welcome to the Sharpe Two Option Quiz!

Every Friday, we will challenge you with a mix of fundamental theory and real-world questions to test your options trading knowledge and get you one step closer to mastery.

Ideal for those keen to hone their skills on the art of options or prepping for a job interview, our quiz offers a concise yet insightful way to test and expand your understanding. You will find three sections:

• Theoretical Value: Sharpen your grasp of options theory and its foundational principles.

• Capital Concepts: Apply theoretical knowledge through the lens of a retail trader navigating real market events.

• 7-Figures Bonus: Step into the shoes of a professional trader and tackle complex, high-stakes scenarios on the trading desk.

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Theoretical Value Questions

Question 1

• Describe how Gamma exposure changes for an at-the-money (ATM) option as it approaches expiration.

• Discuss the practical implications of Gamma risk for a retail trader managing a delta-neutral portfolio. How does this risk intensify in the final week before expiration, and what strategies can the trader employ to mitigate it?

Question 2

• Define Vega and explain its significance in options trading, particularly with implied volatility.

• Imagine a scenario where you notice a pronounced volatility smile in the options market for XYZ Corp. Describe how Vega would vary across different strike prices (ATM, ITM, OTM) in such a scenario.

• How could you use this information to adjust your trading strategy as a retail trader, especially in a market environment characterized by significant uncertainty or expected volatility events?

Capital Concepts Question: Fed Rate Decision and Options Positioning

Scenario

A retail trader, anticipating a surprise Federal Reserve rate change (either a cut or an increase), has strategically positioned themselves in the options market. With the announcement expected in three days (3 DTE), the trader has made the following moves:

1. Short a straddle in SPY (S&P 500 ETF) with an expiry of 5 days (5 DTE), betting there will be minimal movement in the market before the announcement.

2. Long a straddle in SPY with an expiry of 21 days (21 DTE), to capitalize on potential large movements following the announcement.

3. Long a 20 delta strangle in SPY with an expiry of 42 days (42 DTE), positioning for significant market movements either way, but with more emphasis on extreme movements.

This question focuses on the dynamics of Vega and Theta as the event approaches and how these Greeks impact the trader's P&L, particularly the increase in Vega leading up to the event, offsetting the effects of Theta.

Question 1: Pre-Announcement Analysis

Discuss how the Vega and Theta of the trader's options positions (short-term, medium-term straddles, and long-term strangle) might behave as the Federal Reserve's rate decision approaches. To his surprise, the trader is losing money on his three positions.

Discuss the different types of risk in each expiration using the Greeks to explain why he is losing money. Suggest some adjustments as the decision gets closer.

Question 2: Post-Announcement Analysis

Following some advice from more experienced traders, the trader got rid of his short-term straddle and kept its longer straddle and strangle as such. Imagine the Fed announces a surprise rate increase. The market initially moves down, increasing volatility quite significantly. But in a surprising turn of events, it stabilizes and holds up better than expected.

The trader now needs to evaluate the P&L variations and identify the risk in their current positions:

• Given their specific positions, how would the trader's P&L likely have changed immediately following the announcement? Consider the impact of the market's initial downward move and a spike in volatility and how they will affect the straddle and the strangle differently.

• Discuss the role of Charm (Delta decay) and Vanna in the post-announcement market environment. How might these Greeks influence the risk profile and P&L of the trader's positions, especially given the unexpected market resilience?

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Scenario Analysis: Market Turbulence and Long Volatility Positions

Going into the end of the year, a trader has had to buy a lot of straddles and strangles to customer banking on a relatively quiet end-of-year period. He is mainly long in expiration from 15 DTE to 42 DTE. He has decided not to hedge with a calendar spread (basically buying the same position but at a later expiration) because the volatility in later expiration was too expensive for his models. He is left with delta hedging dynamically the position.

To his demise, the market’s volatility sharply increased due to an unexpected rate cut by the Fed, signaling the market that the economy may not be as solid as possible.

The market tanks initially before recovering and starts a period of wild up-and-down reversal movement but without going anywhere much. After a while, even the volatility starts to decrease.

Describe the pnl of the portfolio and the effectiveness of the active delta hedging strategy, especially with the market going nowhere and the expiration getting closer and closer. Suggest what the trader could do to diminish the effect of Charm and Vanna.

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Theoretical Value Answers

Question 1

• Gamma measures the rate of change of an option's delta relative to changes in the underlying asset's price. As expiration approaches, Gamma exposure for at-the-money (ATM) options increases. This is because ATM options are susceptible to movements in the underlying asset price as they hover around the point where they might move from being out-of-the-money to in-the-money or vice versa.

• For a retail trader managing a delta-neutral portfolio, Gamma risk becomes crucial as expiration nears. A delta-neutral strategy, which aims to have the portfolio's delta close to zero, can quickly become unbalanced due to the heightened Gamma sensitivity of ATM options. This is especially true in the final week before expiration, where small movements in the underlying can lead to significant changes in the delta.

• The trader can frequently rebalance their portfolio to mitigate Gamma risk to maintain delta neutrality. Another strategy is to engage in Gamma scalping, which involves dynamically adjusting the delta by trading the underlying asset to capitalize on small price movements. Alternatively, the trader can reduce Gamma exposure by avoiding or reducing positions in short-dated ATM options.

Question 2

• Vega represents the sensitivity of an option's price to changes in the underlying asset's implied volatility. It is crucial in options trading because it helps gauge how an option's value might change as market expectations of future volatility shift.

• Vega varies across strike prices in the presence of a volatility smile. Typically, Vega is higher for options that are in-the-money (ITM) or out-of-the-money (OTM), where the smile is more pronounced and lower for at-the-money (ATM) options. This is because ITM and OTM options will have more pronounced changes in their premiums for a given change in implied volatility compared to ATM options.

• A retail trader can use this information to tailor their trading strategy, especially in markets with high uncertainty or expected volatility events. For instance, if a trader anticipates an increase in volatility, they might favor buying options with high Vega (ITM or OTM options in a volatility smile context) to capitalize on the increased premium from the rise in volatility. Conversely, in a stable market, they might prefer selling high Vega options to benefit from volatility contraction. Understanding Vega and volatility smiles allows traders to make more informed decisions about which options to trade based on their view of future volatility and the current market environment.

Capital Concepts

Question 1: Pre-Fed Announcement

1. Short 5 DTE Straddle (SPY):

   • Vega Risk: As the rate decision nears, implied volatility tends to increase, which is unfavorable for the short straddle position. The rise in Vega increases the value of the options, potentially leading to a loss since the trader is short.

   • Theta Benefit: The Theta, or time decay, should benefit the short straddle as it approaches expiration. However, the heightened Vega likely overpowers the Theta effect in this scenario.

   • Risk Type: The primary risk is Vega (implied volatility risk), causing the loss due to the rising implied volatility ahead of the Fed announcement.

2. Long 21 DTE Straddle (SPY):

   • Vega Benefit: The increase in implied volatility should benefit this position, as a higher Vega would increase the value of both the call and put options in the straddle.

   • Theta Risk: Theta decay is still present despite the potential Vega benefit. However, with 21 DTE, the Theta decay is not as rapid as in the 5 DTE straddle.

   • Risk Type: The key risk here is balancing the positive Vega impact against the negative Theta impact. The trader might face losses if the Vega benefit is insufficient to offset the Theta decay, especially if the market hasn't moved much.

3. Long 42 DTE Strangle (SPY):

   • Vega Benefit: Similar to the 21 DTE straddle, the increase in implied volatility should increase the value of the strangle. However, the benefit might be less pronounced since strangles are less sensitive to at-the-money movements.

   • Theta Risk: Theta decay is slower given the longer duration, but it is still a factor eroding the value of the options.

   • Risk Type: The risk is a combination of Vega and Theta, with the potential for loss if the increase in implied volatility is not substantial enough to overcome the slow but steady Theta decay.

Suggested Adjustments as the Decision Approaches

• Short 5 DTE Straddle Adjustment: To mitigate Vega risk, the trader could consider buying back the short straddle to cut losses, especially if implied volatility continues to rise. Alternatively, rolling the straddle to a farther expiration date might reduce Vega exposure.

• Long 21 DTE Straddle Adjustment: The trader could consider selling portions of the straddle to realize some gains from the increased implied volatility or hold the position if they anticipate significant post-announcement movement.

• Long 42 DTE Strangle Adjustment: The trader might adjust the strikes of the strangle to be more sensitive to potential market movements or sell a portion to reduce exposure and lock in some gains.

Question 2: Post-Fed Announcement

1. Impact on the Long 21 DTE Straddle:

   • Immediate Reaction: With the Fed announcing a surprise rate increase, the market's initial downward move would increase the value of the put component of the straddle, improving the trader's P&L.

   • Volatility Spike: The significant increase in volatility would boost the value of both the call and put options due to higher Vega, further enhancing the trader's P&L.

   • Market Stabilization: As the market stabilizes, the put option might lose some value, but the increased volatility may continue to support the overall value of the straddle.

2. Impact on the Long 42 DTE Strangle:

   1. Initial Market Move: The long strangle, with its 20 delta positioning, would also benefit from the market's initial drop, particularly the put side.

   2. Volatility Influence: The spike in volatility would positively impact both the call and put options of the strangle, potentially leading to a significant increase in P&L.

   3. Post-Stabilization: Even with the market stabilizing, the long duration and wide strikes of the strangle might retain some increased value due to the elevated volatility level.

Role of Charm and Vanna Post-Announcement:

1. Charm (Delta Decay):

   • Influence on Positions: Post-announcement, Charm becomes significant, especially for the 21 DTE straddle. As time passes and the market stabilizes, the rate at which Delta changes (Charm) will affect the sensitivity of the options to the underlying SPY price.

   • Effect on P&L: If the market stabilizes and moves less than expected, the charm will cause the Delta of the options to decay, potentially leading to a decrease in the value of the straddle, mainly if the market doesn't move significantly in either direction.

2. Vanna (Change in Delta due to Volatility):

   • Influence on Positions: Vanna will play a crucial role in the immediate aftermath of the announcement. As volatility spikes and stabilizes, the Delta change in response to this volatility shift will impact the straddle and strangle differently.

   • Effect on P&L: Being closer to ATM, the straddle would see a more pronounced effect of Vanna. If volatility starts to decrease post-stabilization, the decrease in Delta will affect the straddle's value. With its out-of-the-money positioning, the strangle might see a less immediate impact but will still be influenced by the changes in volatility.

In conclusion, the trader's P&L would likely have seen an initial boost due to the market's downward move and a spike in volatility, positively affecting both the long straddle and strangle.

However, he would then have some significant delta exposure (negative delta) and vega exposure. As the market stabilizes and volatility levels off, the dynamics of Charm and Vanna would play critical roles in determining the ongoing risk profile and P&L of these positions. The trader must be vigilant about these changes and consider potential adjustments, especially if the market continues to hold up unexpectedly well post-announcement. The best way would be to manage his delta exposure actively, especially after the announcement, to lock in some profit and diminish his exposure to the unexpected turn of events.

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Portfolio Composition

• The trader has bought a range of straddles and strangles, betting on a quiet market period.

• These positions are long volatility, so they generally benefit from increases in market volatility.

• The absence of calendar spread hedges exposes the trader to near-term volatility swings.

Market Reaction to the Fed's Rate Cut:

• Initial Reaction: The market's sharp downturn and the increase in volatility following the Fed's rate cut initially benefit the trader's long positions, as the increase in Vega leads to an increase in the value of the straddles and strangles.

• Subsequent Market Fluctuations: The market enters a phase of high volatility with significant up-and-down movements but overall remains range-bound. This erratic behavior can be challenging for portfolio management, especially as options expire.

Portfolio P&L and Delta Hedging Effectiveness:

• P&L Impact: Initially, there's likely a positive impact on P&L due to the spike in volatility. However, as the market stabilizes and volatility decreases, the value of these long volatility positions may start to decline, especially as expiration approaches.

• Delta Hedging Challenges: Maintaining an effective delta hedge is difficult in a volatile, range-bound market. The frequent adjustments required to rebalance the delta in response to market swings can lead to significant transaction costs and potential slippage.

• Effect of Decreasing Volatility: As volatility starts to decrease, the Vega of the positions decreases, potentially reducing the value of the long straddles and strangles.

Mitigating the Effects of Charm and Vanna:

1. Charm (Delta Decay) Management:

   • As expiration nears, the Delta of the options will decay (Charm effect), particularly for those options that are near the money.

   • To mitigate this, the trader could look to roll out some positions to longer-dated expirations to reduce the immediate impact of Charm.

2. Managing Vanna's Influence:

   • Vanna measures the change in Delta for changes in volatility. As volatility decreases, the Delta of the options will also change, affecting the delta hedge.

   • The trader can adjust their delta hedging strategy more frequently to account for these changes, although this could increase transaction costs.

3. Potential Portfolio Adjustments:

   • Profit Taking: If some positions have accrued significant profits due to the initial volatility spike, the trader might consider taking profits to reduce exposure.

   • Diversifying Strategies: Introducing other trading strategies or positions that benefit from decreasing volatility or range-bound markets can help balance the portfolio.

Adjustment

• The best potential adjustment to diminish the cost of delta hedging and the path dependency effect - with the stock going nowhere - the calendar spread starts to become more attractive

• If the volatility is still costly in the back month, the trader could decide to sell some strangles to manage his delta and vega exposure.

In conclusion, the trader's long volatility positions face a challenging environment due to the volatile but directionless market post-Fed announcement and the subsequent decrease in volatility. Managing the effects of Charm and Vanna becomes crucial, and strategic adjustments to the portfolio and a flexible delta hedging strategy are key to navigating this period effectively.

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