Big Printin’ – The Home Depot (HD) and Delta Neutral Lessons

by CC April 10, 2017 3:31 pm • Big Printin'

On of the largest single stock options trades on the day was in The Home Depot (HD). Shortly after noon, a trader bought 25,000 of the May 155 calls for 61 cents and sold 450,000 shares at $147. I suspect this was a trader or an investor making a directional bet, or possibly levering up an existing long position. In this space we don’t often highlight large options trades that are tied to stock, but in this case, this position traded on an 18 delta, meeting for every 1000 contracts purchased, 18,000 shares of stock were sold at $147.

There are several reasons why a large trade is put up as delta neutral with stock. It could be that the customer simply wants to put on a trade delta neutral, buy low vol, sell high vol, scalp, profit. Or it could be that an investor wants to replace some stock with calls. And a very common scenario is that on such a big block of calls, to secure tighter pricing to put the trade on delta neutral, get the options trade done without having to pay through the offer and present the options market makers with a simple trade all wrapped up in a bow. From a market maker’s perspective being brought the trade delta neutral takes away one of the main pricing advantages on the options side and the sale price on the options ends up more competitive as a result. The customer can then likely find more liquidity on the equity side to buy back the shares sold as part of the package.

But let’s assume this trade was delta neutral because there’s some interesting things to talk about on that front. On a basic level, buying calls and selling stock delta neutral is creating a synthetic long straddle. Here’s the easiest way to think about that using a 50 delta option (at the money) to break down the trade into parts.

If you buy 2 calls, and sell 100 shares delta neutral, what you have done is bought 1 call, and bought one put synthetically. How is that? If you pair up the 100 shares sold with one of the calls bought, that is a synthetic put, the other call is, of course, is still a long call.

Synthetic Straddle from buying 2 calls and selling 100 shares of stock (delta neutral) =

Call (+50 deltas) : Long 1 call

Synthetic Put (-50 deltas): Long 1 call (+50 deltas) and Short 100 shares (-100 deltas)

What that means for a delta neutral trader is that if the stock rises, the call portion of the synthetic straddle increases in deltas, and the synthetic short portion decreases its short deltas. So as the stock rises, the position gains deltas, and stock can be sold against those deltas to stay neutral.

If the stock goes lower, the synthetic put portion of the trade increases its short deltas, and the other call decreases its long deltas. If the stock goes higher, and then lower, and then higher again, you can sell stock, buy it back and sell it back, over and over all along matching up the deltas of the position at the end of the trading session. Ideally making money scalping the stock in excess of the decay of the premium as you approach expiration. Buy and sell enough stock as it rises and falls enough and you can make money without ever having any risk on deltas. You’re completely ambivalent about whether the stock goes up or down, you just want it to move. That makes sense because you are long a synthetic straddle!

The other way you make money from delta neutral trading is by vol rising or falling from your entry point. Delta neutral traders make their most money from buying low vol, and selling high vol. So let’s go back to this HD trade because… it is really low vol. the calls were purchased at about a 15% implied volatility. Here’s how 15% vol looks on a 2-yearr chart (implied vol in red):

It’s pretty close to historical lows. You’ll notice the blue line, that’s realized vol, how much the stock is moving day to day. It’s near 8%! That makes sense because the stock has barely moved since February.

So how does a trader make money off low vol in this scenario? If that low realized vol were to continue into May expiration it will be tough. Scalping will be tough as the stock barely moves, even with less premium to decay with the low implied vol. But if the stock were to make a move out of this consolidation the delta neutral trader can make money as vol increases, and the premium of both the call and the synthetic put increase with a rise in vol. And that would be a two fold victory as more scalping at better intervals becomes possible with larger moves in the underlying as well as an increase from the vol entry.