Trading Options at Expiration : Strategies and Models for Winning the Endgame (9780137013517) by Augen Jeff

Author:Augen, Jeff
Language: eng
Format: epub
Publisher: Prentice Hall
Published: 2009-11-14T16:00:00+00:00

Figure 2.4 Minute-by-minute trading profile for MasterCard on January 18, 2008. The stock began to oscillate around the strike price at 12:00 and finally pinned around 14:30. From this point on, the stock traded in a very narrow range. Time is displayed on the x-axis, price on the y-axis.

On this particular trading day, because of the large number of oscillations around the $175 strike, each minute had a 23% chance of containing a strike cross. The total number of crosses (91) is the largest on any of the lists. In addition, the number of minutes more than $1 away from a strike shrank to 102—the lowest value for MasterCard in the 12-expiration time frame. Unfortunately, a long straddle placed at the time of the first strike cross would have failed because the magnitude of the stock move was too small to generate a profit. At 12:02, when the stock traded at the $175 strike, an at-the-money straddle traded for $3.05 ($160 call/$1.45 put). A few minutes later, at 12:19, with the stock at $173.70, the trade was worth only $2.84 ($0.84 call/$2.00 put). In the next few minutes, it reversed direction and returned to the $175 strike (12:28). The best decision would have been to close the position at this time with a small loss (the options traded for $1.40 call/$1.40 put).

The more reliable ratio trade, which depends on falling implied volatility and is hedged against underlying price changes, would have been a better choice. At 12:02, when the stock crossed the $175 strike, a 1:3 ratio trade consisting of long $170 calls and short $175 calls would have been net long $0.20 ($5.00 for the long $170 calls – $1.60 × 3 for the short $175 calls). The trade would have delivered steady profit as implied volatility fell and time decay eroded the option prices. At the closing bell, the long $170 calls traded for $4.60, and the short $175 calls could have been repurchased for $0.10. The position would have been net long $4.30, and the total profit would have been $4.10 from an investment of only $0.20. The ratio trade was an excellent choice because it had virtually no downside risk (the short side paid for the entire cost of the long side), and was somewhat hedged by the long $170 calls against an upside move of the stock. In this regard, the trade would have returned a profit even if the stock climbed $1.60 because the long side would have gained $1.60 and the short side would have been worth its original sale price.

For comparison, an investor who decided to sell naked puts and calls when the stock returned to the $175 strike at 12:28 would have generated profit of $2.30. (The straddle sold for $2.80 at 12:28, and only $0.50 at 16:00.) This trade also delivered steady profit and was hedged against a $2.80 move in either direction. Despite its success, the trade was a poor choice. Pure naked short positions are safer late in the day when implied volatility collapses quickly.

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