The Mechanics of Smart Money & Delta Hedging

For every option that is bought, there is one sold...in other words a “zero sum game.” Many times it is a brokerage dealer, market maker or derivatives shop shorting the options and throw them into their much bigger vol book that they trade.

Part of the reason we see outsized moves is when a stock starts moving the dealers who are short the calls need to buy more stock to hedge. This can easily double the amount of buying pressure out there and lead to very exaggerated moves.

As the stock goes up, so does the delta of the stocks calls and dealers who were originally perfectly delta hedged before the move effectively become short the stock as it moves higher so they need to buy more stock to “hedge up” or flatten their exposure/risk.

They are also highlighting big “wiseguy trades” or "smart money trades" ...big call trades most likely put on by a hedge fund or other large institution that are likely betting on an expected large near term move...so when stocks gap up dealers need to rush and re-hedge or risk getting short as that move plays out.

Worst thing for a dealer who is short large options is gap risk...can't really hedge against that risk except by buying other options beforehand which can get expensive for them.

Almost all the large option trades are traded through sell side (brokerage firms) option trading desks. There is no liquidity in most stock options (besides index) to trade 5k+ contracts at a clip w/o dramatically affecting the price or ie: affecting the options volatility assumptions

Example:

I am a trader at a hedge fund and I call a brokerage firm options trading desk and say I want to buy the $GM April 40 calls or say “give me a menu” (for bigger trades)....screen has them 35c/40c...they respond, 1k at 40c, 2500 @45c or 5k @50c

I'll say "I paid you 50c for 5k" 

Now they are instantly naked short the calls

Then they go and see if 

1) they have a view on the stock or it helps their overall risk to hold onto them so they may decide to keep them (rare)

2) see if they can get out of the risk w/o moving the market...first to clients or there is a whole brokers broker market where dealers can offload some risk w/o going to clients or the public. They will also see if there is some liquidity in the screen markets...usually good for smaller trades.

For big trades this isn't good enough. then:

3) they will try to hedge themselves by buying other options...either higher strike or create synthetic calls (buy puts + buy stock) but this is expensive and hurts potential gains they were hoping for on trade

4) just buy the amount of stock of the option delta...with GM at say 37 the April 40's are ~.20 delta so they would have to buy 100k of stock (5000 calls x 100 multiplier = 500k shares x .20 delta = 100k to be currently delta hedged).

This works until stock jumps 5% and the call delta goes from .2 to .4 and the dealer is forced to buy 100k more stock to hedge his delta risk otherwise he effectively become short the other 100k shares.

GM is an easy example but imagine a stock that only trades 200k a day and a dealer is short 5k calls...the buying snowballs and that's when you see a 3% move quickly turn into a 10% move for no other reason than dealers freaking out about their risk...and as they buy more stock the stock goes even higher & so does the delta causing them to need to buy even more = stock going parabolic scenario.

I’ll also add that when a stock starts moving up quickly for no obvious reason nobody wants to short it or even sell a long position because people naturally think that someone knows about some positive news coming out and the recent large call buying adds credibility to that thought process. Also you have daytrader types that jump onto anything that's moving hoping to catch a profitable ride on the positive momentum. This removes liquidity and creates a situation with buyers dramatically overwhelming sellers and thus the stock can have a quick, crazy move higher.

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