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Trading Arch Coal


This is the nature of selling premium

Arch Coal (ACI) reported really good earnings. The stock is up 10% today after rallying significantly over the last month. So that's the story. Well, not quite.

In late March, a call seller appeared and sold a large amount of July 70 and 85 calls very cheaply. We bought them and shorted stock to delta hedge them.

Now look at a chart of the stock to see how it has traded. It has all the hallmarks of a short squeeze due to short gamma.

The call seller most likely had a fair amount of long stock protecting the short 70 calls since they had a .6 delta when they were sold. As the stock rose this strike presented little problem for the seller.

But the 85 calls had a very small delta. Most likely the seller sold these with little long stock held and was probably just looking for that little "extra" income kicker thinking there was no chance the stock ever gets to 85.

As the stock continued higher he most likely sat tight and lived with the exposure. But after earnings today and a rise through the strike this "trader" short these calls probably could not handle the losses (short gamma acts like leverage) and began to buy stock to protect the exposure. This led to frantic buying. The person short the calls began to work against himself.

And of course we have not helped much. We realized the situation early today and really did not sell much stock to hedge our now ever increasing delta. We have since helped the call seller by selling stock more aggressively here to hedge our own position.

And so now the call seller has covered his exposure by buying stock here against the short 85 calls. He is fine now, right?

Not really. Now if the stock begins to decline below 90 then 85 then 80 the call seller is left with long stock. Again, he may last for a while holding onto the stock with the calls going down to almost zero in price, but at some point he will feel the same pressure and begin to sell this out.

And we will be there to buy our short stock back. We'll help him, but as little as possible. We both have until July to see how many times this process will repeat itself (it is likely to repeat the next time to a lesser degree each time).

This is the nature of selling premium. When sold cheaply it opens the door for magnified moves, creating more volatility than would normally be there.
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