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Anatomy of a Trade



Note: Professor Succo is a seasoned derivative trader who is well versed in the risks of the option market. He shares the following dialouge with educational intents. This is not offered as advice but rather as a real-time lesson of risk management.

Todd tells me that many thought I lost money in describing buying cheap calls in such stocks as UPS (UPS:NYSE), Johnson & Johnson (JNJ:NYSE), and Freddie Mac (FRE:NYSE). Not true.

Remember, what I care about is the price in relative implied volatility terms. This means that I care only about where the calls are trading at versus where the stock is trading. If I buy calls at $.50 and sell stock at $50 and the calls are still trading at $.50 when the stock is at $49 I look at that as making money. This means that there has been an expansion in implied volatility and I can sell other options in a way where I can lock in profits. I assume that the options will eventually go to zero; all I care about is the daily trading volatility of the stock until they do.

So I have made money lately as there has been a moderate but significant (at least to me) expansion in implied volatility in several stocks. Normal traders would not notice this, for they have occurred in the hidden shadows of the market where only a few tread. They are the result of "people doing stupid things", selling options just too cheaply to earn a few pennies.

I am currently building a position in Eli Lilly (LLY:NYSE) in October. Long holders of stock who over-write (hedgers who think there is only a small downside in the stock) are selling out of the money calls in an attempt to hedge (the income of the calls will partially offset any short term declines of the stock) what is likely to be an eventful next few months for the company. Other long holders of stock are buying out of the money puts (hedgers who think there may be more downside in the stock).

The combination of demand for out of the money puts and supply of out of the money calls creates a skew in the implied volatilities of the strikes: the October 75 and 80 calls are very cheap (25% implied volatilities) compared to the October 60 and 55 puts (44% implied volatilities).

So I sell the puts and short stock to hedge the delta; I buy calls and sell stock to hedge the delta. The long calls give me cheap long gamma and vega against the short puts which give me short expensive vega and gamma: overall I am long gamma and earning theta or time decay. For those of you who learned in finance class that you can't be long options and earn money doing so need to get out of the classroom and into the real world of "people paying the wrong price for options".

I manage the delta by adjusting the stock price: I get to make profits trading the stock because I am long gamma. I manage the vega by selling slightly more puts than calls (I am short 1300 10/55 puts and 2500 10/60 puts and long 2250 10/80 calls and 500 10/75 calls); this still throws off a net positive gamma because the forward price of LLY is closer to the strikes of the calls than the puts. The theta is positive: the combination of option positions throws off a positive decay per day. This is a little like getting paid to eat dinner out.

There is risk on this trade of course: I am short a downside tail, although it is very far down in price. Because I am currently long gamma and do not get short gamma until about a price of $59 (the stock is currently $64.75 so this is a drop of almost 9%), the position is not exposed (begins to rapidly lose money) until $49 (down 24%).

To protect against this I have bought 2000 1/80 calls and 1000 longer term calls and shorted more stock delta neutral against them. The stock would have to gap without trading to $42 for me to lose money. This is a risk we take.

On the upside I get very long gamma. The only thing required for me to make money is for the stock to trade at around a 21% volatility (which equates to a range of around 1.3% or $.85 per day) as it goes up.

I am still working into a larger position on this trade. My discussing it will have no impact on option prices: people are going to do what they are going to do no matter what I say. And there are few that are in my position to look at the trade as I do.

Now that I have sketched out the trade I will try to keep you up in what I am doing.

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