Short Selling and a Straddle Surprise
As we all know, the last couple of weeks have been full of surprises. When the Fed and the SEC get involved in changing the rules, surprises are to be expected. It's tough enough trading when we know the rules; in this environment of uncertainty, be extra careful. Since I'm not an expert on the credit/housing/mortgage crisis or the impact they will have on the financial well-being of the economy, I'll leave those issues and their ramifications to those who are experts. I will say however, that in my opinion, the ban on legitimate short selling (not naked short selling which was never allowed), makes absolutely no sense and will tend to hurt rather than help the markets.
Derivative traders, of which we (options traders) are a subset, rely on certain arbitrage relationships (including Put/Call Parity) to help with the pricing process and to maintain an orderly market. If you've been trading since September 18 when the SEC Emergency Order went into effect, you probably noticed wider spreads and less liquidity in the affected stocks. Then on September 21, a Sunday afternoon, the SEC came out with Release No. 58611 (when did the SEC last come out with a release on a Sunday afternoon?) that amended the original rule banning short selling of about 800 financial related stocks by allowing 3 exemptions:
1) Short sales that are the result of automatic exercise or assignment of an equity option held prior to the effective date of the Emergency Order.
2) Short sales that occur as a result of assignment to call writers upon exercise, and
3) Short sales made by a Market Maker that are part of their hedging activity.
This ban was to end on October 2, but has been extended to end no later that October 17, although it may end sooner. As a word to the wise, check with your broker before entering any trades that could result in a short position to see how they will implement the rules. Notwithstanding the exemptions listed above, one broker notified me that:
“…it is your responsibility to close uncovered long put positions before they create a short equity position through exercise.”
Maybe I should send them a copy of this article.
Anyway, while we're talking about surprises, I'd like to point out something, mostly unrelated to the above comments, that I think many readers will find quite interesting. That is the natural downward bias of options. What, options are biased, surely you jest? The truth is that because options are generally priced using a model (typically Black-Scholes), and the model assumes that the distribution of stock prices follows a log-normal distribution, there really is a downward bias.
While the actual mathematics is relatively complicated, let me explain what I mean by looking at how the value of a Straddle (a Put plus a Call with the same strike price and expiration date) changes with respect to price, over time and at various volatility levels.
Assume XYZ = $98 and we're looking at the 100 strike. The options are trading with an implied volatility of 30% and the Jan 2010 options have 115 days to go until expiration. The theoretical values of the Put and Call are 7.24 and 6.03 respectively. Therefore, the Straddle has a theoretical value of 13.27. The delta of the Call is +50 and the delta of the Put is -50, so the delta of the Straddle is 0. (I picked the stock price so that this would be the case.) This position is delta neutral and therefore we would not expect the value of the Straddle to change very much given a small change in the price of XYZ. The purchase of this position might be typical for someone who expects a large move in the stock, but isn't sure about direction.
Now let's fast-forward 58 days. At this point, about one half the life of the options remain and there are 57 days left to expiration. Assuming nothing else has changed, the position has lost nearly 30% of its value, and the delta hasn't changed very much.
A review of the table shows what happens to this Straddle at various stock prices. With the stock up 10 points the Straddle has lost (13.27 – 12.01) or 1.26 in value. Conversely, with the stock trading 10 points lower the straddle has actually gained a small amount equal to (13.31 – 13.27) or .04. Looking at a 20 point move on the upside, with the stock at 118 the Straddle would have gained 6.00, while on the downside with the stock at 78 the Straddle would have gained 8.80. That's 2.80 more on the downside; close to 50% more (46.7% for those of you who demand precision.)
Now we also know that as the price of a stock decreases the implied volatility tends to increase and as the price of a stock decreases the implied volatility will generally increase. Running the theoretical values using various implied volatilities, I find, in addition to giving my options calculator a good workout, the following results:
So the change in implied volatility further exacerbates the situation. Note that while it's improbable that the implied volatility will decrease to less than about 20%, short term increases much greater than 40% are possible. Let's boil this down and examine what it is telling us. You may want to draw your own conclusions, but it seems to me that if you like to trade Straddles because you think you're particularly adept at predicting large moves in the market, but not necessarily direction (granted it's not the most common combination of predictions), then if you're leaning to the downside, put the position on. On the other hand, if you're leaning more to the upside, you might want to investigate other ways of taking advantage of an upside move while still providing profits if a large move to the downside should occur.
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!