- Big week for Straddle Buyers: Average Unhedged Return +43%
- Call values plummet; Put values soar as market takes significant end-of-week downturn
One of the analytical processes we like to run at Market Chameleon is a breakdown of the movement in weekly option values from the beginning of the week through expiration. It allows us to pick apart different option strategies that traders have and see which ones were the most beneficial for the week. To do this, we took an entire set of weekly option expirations and tracked the value of those options (and their underlying stocks) from the beginning of the week (usually 10:00 AM on Monday -- after the markets have opened and products have set a valid baseline) through the end of the week, when the options expire (usually 4:00 PM on Friday). We then compared the total net return for the product as a percentage of the initial option premium invested. Additionally, we compared three different hedging techniques to try and determine which technique returned the best results for the week.
Here are the types of hedging techniques we compared:
- Unhedged: this means we'd theoretically buy (or sell) the option at the beginning of the week and hold it through expiration, returning the realized value of the option
- Hedged Once: this means we'd buy the option and immediately hedge with stock so that our net delta position was neutral, but then hold both the stock and the option until the end of the week, where we'd evaluate the return
- Hedged Daily: similar to "Hedged Once", but in this case, we also hedge with more stock at the end of each week day to neutralize our delta. This strategy results in much more buying and selling of stock shares throughout the week
And we applied these techniques to the following option instruments:
- At-the-Money Straddle: this is one call contract and one put contract for the option strike that is closest to the underlying price. For example, if a stock is trading at $150, we'd buy one call on the $150 strike and one put on the $150 strike. Theoretically, a $150 call option when the stock is trading at $150 has no value, but the markets will still price in a significant premium because there is time remaining before expiration when that option could gain a great deal of value
- 25-Delta Call: this is one call contract for the strike that represents the 25-Delta Call option, or whichever strike is closest to 25
- 25-Delta Put: this is one put contract for the strike that represents the 25-Delta Put option, or whichever strike is closest to 25
Given that there are three hedging techniques and three different option instruments, we are left with nine different strategies that traders could have employed for the week. The simplest comparison of the strategy results is shown in the table below:
Below is a table of market performance of these instruments when left unhedged. It's easy to see that, for the week, ATM Straddle buyers were winners, hitting on 58% of products for an average return of +43%. You'll notice in the table that there are far fewer 25-Delta Calls and 25-Delta Puts than there are ATM Straddles. Weekly expirations will often not have a strike that best represents a 25-Delta option, or if they do, the markets are several dollars wide or there is no trading activity happening on them. For this reason, we exclude options that we can't accurately track, and as a result we end up with fewer out-of-the-money options to analyze.
ATM straddle buyers can typically only win for a week if the volatility of the market spikes. Unlike an out-of-the-money call or put, which can return huge gains if a stock simply moves beyond the strike necessary, ATM straddles require stock volatility to eclipse that which is priced in by the option's premium. For the week ending September 9th, the market saw a huge surge of volatility, mostly on Friday the 9th, when the S&P 500 SPDR (SPY) dropped -2.4% and saw SPY 30-day Implied Volatility climb +54% from 9.2 to 14.1. This increased volatility resulted in big wins for straddle buyers, and the drop in stock prices resulted in big wins for 25-Delta Put buyers, as indicated by the net +239% return. On the flip side of that, upside speculators who bought out-of-the-money calls were net losers, dropping -51% of their value from Monday morning. Nearly 92% of all out-of-the-money calls ended up losing all of their premium, meaning the stock price didn't reach the necessary strike.
Market index ETFs like PowerShares QQQ and SPDR S&P Mid-Cap 400 (MDY) were big winners for downside speculators. While QQQ dropped -2.4% on the week, which would have been good for short sellers, the 25-Delta Puts for the 09-Sep-16 expiration ended up being a much more productive investment. They returned +893% unhedged by the time the options expired on Friday afternoon. The 25-Delta Calls, on the other hand, expired at with no value, losing 100% of the initial investment. Apple (AAPL) similarly was a big downside winner for the week, as its 25-Delta Puts returned +700% from Monday morning.
Hedged Strategy Results (Hedged Once or Hedged Daily)
While unhedged option returns gives us a good indication of what happened in the options market from the start of the week to the end of the week, it's important to note that many option traders hedge against their delta positions, and the returns produced from hedged options often times differ greatly from unhedged options.
Below is a table comparing the returns of ATM Straddles when unhedged, hedged once at the trade, and hedged daily.
You can see that the differences in returns from unhedged to hedged once are minor. This is likely because an ATM straddle typically produces a very small net delta, so when it is hedged at the time of the trade, you would only end up trading a few shares of stock. However, because market movements can shift deltas around significantly over the course of the week, hedging daily returned significantly more winners for straddle buyers by the end of the week, and produced far fewer losers. As the volatility increased and the stock price moved up and down, hedging presented more chances for traders to buy the stock low and sell high (or sell short high and then buy back low).
An example of this difference can be seen in the video streaming service Netflix (NFLX), which opened the week with a +2.8% gain on Monday and closed the week with a -3.2% loss on Friday. Buying the straddle unhedged throughout the week would have net traders +7.6%, but hedging deltas daily would have returned +74% by the end of the week.
You can also see the effects of hedging when comparing the results of the 25-Delta Calls below.
In this case, it was much more valuable to hedge the deltas for the week than to leave the options as speculative investments. Over 92% of the calls lost value by Friday, and hedging the delta would have meant selling the stock, providing an opportunity to buy it back at the end of the week once stock prices had plummeted.
The reverse could be said about 25-Delta Puts. Buying puts requires the trader to buy stock in order to hedge the risk, and we already saw above that a great percentage of the market's stock prices went down over the course of the week. Any gains in value earned by the out-of-the-money puts were slightly offset by losses in the shares of stock owned by hedged traders.
Still, in this case, hedging daily produced fewer losers on the week. It makes a lot of sense -- by hedging, traders are eliminating some portion of risk, while at the same time lowering the ceiling of potential positive gains made by speculative option trades. Hedging the put trades for the week ended up producing more winners, however those winners were of smaller magnitudes than leaving the puts unhedged.