It may seem to be counter-intuitive at first, but there are times that traders engaged in selling premium in options will want to take a short (or long) position in the underlying to hedge. The objective in doing so is to benefit from “Static Delta”. Every option position has a Delta figure. An option position’s Delta is always subject to Gamma risk but not a Static Delta position such as an underlying. Additionally, a premium seller benefits from short Static Delta as it offsets not only Gamma risk but Vega risk too. Vega, one of the option Greeks, is a measure of risk related to changes, usually increases, in Implied Volatility (IV). So how does this all work in practice?
The Option Jive from July 26, 2016, "Comparing Movements in SPX and the VIX" demonstrated that when the SPX decreases by 1% the VIX increased (on average) by 1 point. A chart was displayed which helped to explain this. Using these figures an example was provided to show how to put this to use. The Vega risk divided by 1% of the current SPY price provides an SPY weighted Delta number. So if the Vega figure is -100 and the SPY price is $217 than -100 divided by the product of 217 multiplied by 0.01 results in a short SPY Delta figure of 46. So if the SPY declines 1% or 2.17 points the short 46 shares will gain about $100 offsetting the resulting loss of $100 from a 1 point increase in Vega.
Things are not so simple when it comes to offsetting Gamma risk. A lot comes down to trader preference. While short Delta can help protect a short premium position, especially from the outlier moves to the downside, it is a constant drag on portfolio P/L in a bull market. For example if you sold a SPY Straddle with a Gamma of -10 at order entry just before the Aug 24, 2015 selloff you would benefit from short Static Delta. A graph comparing adding various short SPY Deltas to a Straddle was displayed. The levels were 3x Gamma (30 Delta), 6x Gamma (60 Delta) and 9x Gamma (90 Delta). The 9x Gamma performed the best in a market selloff but got hurt the most in a market rally. We need to balance protection with minimizing upside risk.
Tom noted, “The reason that most people in general don't learn any depth about finance is that they play a black & white game that doesn't move. We on the other hand play an active game that’s constantly changing and the rate of that change, changes as well all the time.”
Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for the key takeaways and the benefits of using short Static Delta to mitigate Vega and Gamma risk.
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