Executive summary

In this issue, Rich examines the trade-off of delta hedging profits, known as gamma scalping, versus time decay using Micro Bitcoin options to illustrate.


In previous Excell with Options issues, I have focused primarily on trades with a bit more explicit break-evens. Not all were strictly directional idea implementation, as calendar spreads were included. However, they were all pretty much binary in that you would know within a short period of time if the idea was going to work or not. Each strategy was built around having a view or a position that had a directional bias, but that also incorporated whether the level of implied volatility was deemed to be fair, expensive, or relatively inexpensive.

When trading options, ultimately, one needs to take a view of both the direction and speed of a market. When I say the speed of the market, I mean the trader needs to take a view on the future volatility of the underlying and not just the direction of the underlying. In the following table, I charted the types of strategies a trader may consider based on whether their underlying view is bullish, neutral, or bearish, and if future volatility is high, low, or just about average.

Figure 1: Option strategies: Direction and Volatility

In a year like 2022, with so many moving parts, it would not be surprising for a trader to have no real directional view, while also considering that markets may remain highly volatile. There still is a major conflict ongoing in Europe, commodity prices are at a decade high, and the market is facing a potentially aggressive central bank hiking cycle. All while, by some estimates, the valuation of riskier assets is considered to be full.

Based on the chart above, this might suggest a straddle-buying strategy. Last week, we reviewed buying a straddle and compared the breakeven prices of the straddle to the current level of the underlying and its potential moves. That is one method to consider the price of the straddle.

Another is to buy the straddle and aggressively delta hedge over the life of the option. For this example, I will use options on Micro Bitcoin futures, which just started trading this past week but still serve as a good case for the analysis.

First, consider the price of the May Micro Bitcoin futures. In 2022, it has ranged from 49,000 on the upside to 35,000 on the downside. Additionally, it has rallied back above 45,000, above the midpoint of the range in which it has been. For the purposes of this example, assume the trader has no strong fundamental or technical directional view but does think the underlying will remain volatile.

Figure 2: Micro Bitcoin (MBT) futures

Figure 1 charts one’s view based on the underlying futures contract’s realized or historical volatility. However, when trading a straddle, one should also consider what the market is pricing into the options currently. For this, one could compare the implied volatility of the market versus the realized volatility to see the amount of risk premia that the market is seeking in pricing the options. The chart below (Figure 3) plots three points – recent historical volatility, the price of the underlying, and the newly priced options implied volatility.

This chart displays two things:

  1. The historical volatility of the underlying had been falling most of last year, to end the year, near its lows for the year. However, in 2022 it had more than doubled before settling back down.
  2. The implied volatility (blue) is priced at a no premium to the realized volatility and this level of implied at 58 is in the lower third of the range for all of 2022. Thus, one may conclude that the implied volatility could be considered to be fair and a long straddle position may be justified.

Figure 3: Bitcoin Dec 2021 – March 2022

Now let’s consider the explicit cost of the options. For this, I use QuikStrike’s SpreadBuilder. Since the underlying price is quoted at about 45,500 (at the time of this writing), I have looked at the May 45,500 straddle. Pricing this on a 58 implied volatility, the total price paid in points is just over 8200. The position is essentially delta neutral, at the start, and has breakevens on the graph at about 37,000 and 53,500. However, we are not looking at this as a breakeven opportunity, we are looking to use this strategy to delta hedge throughout the life of the option. The graph on the right shows a straddle position is an instant gratification idea. The greater and sooner the move, the better the potential. This is shown from the shallowness of the breakeven graphs in the early days. Over time, as theta of the options really takes hold, the breakeven graph becomes sharper, and bigger moves are needed to achieve positive expected return.

Figure 4: Micro Bitcoin option straddle

Let’s assume that there is positive news in the crypto world tomorrow. The price of Micro Bitcoin futures have moved up to 50,000 and, because of the pace of this move, we will assume that implied volatility remains firm at 58 and does not come lower based on the direction of the move. Therefore, we reprice the straddle. The straddle we bought at 8200 has increased to 9330 in price. We can see that the delta of this straddle has also increased to .40 or 40%. This means the delta of the call is 70 and the delta of the put is -30. Our straddle position now has a theoretical delta that is long. If we are still largely neutral on direction – perhaps because we are at the high end of the range for 2022 but still think historical volatility may remain high – we will flatten this delta by selling .40 futures for every option we bought of the straddle. For instance, if we bought 100 straddles, we would have 40 futures to sell. After we have executed this Micro Bitcoin futures trade, our resulting position would be flat.

Figure 5: Micro Bitcoin option straddle with futures increase

Let’s then assume that there is negative news in the market over the course of the day. Perhaps there is a negative headline on regulation in the U.S., or some negative headlines about proof of stake being delayed, etc. I am not suggesting that will happen, but for the purposes of our example, let’s assume that there is negative intraday news and the price of Micro Bitcoin plummets. Recall that it was 50,000 when we walked in first thing in the morning. Let’s assume it falls all the way to 40,000, below the midpoint of the range. The straddle that we bought, that had gone up in price to 9,330 from 8,200, now falls back to 8,900. Because of the magnitude of the move, it has not fallen back to or through the price we bought it at, but it has fallen from the morning. Importantly, we can see from our option pricing tool that the delta of the straddle is now -35 (32 on the call and -67 on the put). For every straddle we bought, we are now short .35 futures. For the 100 straddles we discussed earlier, we are now short 35 futures. Also remember that we had sold 40 futures at 50,000 to flatten our delta because we did not have a strong directional view on the underlying. Our view was on the potential for volatility. Now, we not only have to buy back the 40 futures that we sold before, but we have 35 more futures to buy to get flat. We buy the 75 futures at 40,000 to remain delta neutral since our view is still only on the potential for volatility.

Figure 6: Micro Bitcoin option straddle with futures decrease

In this stylized example, we entered into a position on a May straddle because we didn’t have a view on the underlying direction but thought that the realized volatility would remain high. We watched as the underlying went much higher, and then much lower, ultimately ending below where we entered the trade. However, because it did so in a volatile fashion – in line with our view that historical volatility would remain high – our trade profited. Our view on volatility was correct, so we should expect to profit. In this case, we made 700 points (8,900-8200) on every straddle we bought and made 10,000 points (50,000-40,000) on every futures contract we traded. Recall, the multiplier on Micro Bitcoin is .10 - that equates to $70 on the straddle and $1,000 on the futures.

Of course, the underlying price will not always move so much immediately after you put on a position. Often the trader must battle the time decay or theta of the position. Every night, because of theta, the value of the straddle will slowly erode. Options have a time component to the valuation. The longer it takes for the underlying to move, the more the position will decay the profits. However, if the underlying does move in a volatile fashion, the position can profit by actively trading the change in delta even if the position erodes. For example, let’s assume that it took 10 days for the Micro Bitcoin futures to move up to 50,000 and then back to 40,000 as they did above. In this case using QuikStrike’s SpreadBuilder but decreasing the number of days to maturity by 10, we can see that the price of the straddle has now fallen to 7,460 from 8,200. Our profit on the trade would now be -740 points (7460-8200) on every option we traded, but we still would have made 10,000 points (50,000-40,000) on every futures we traded. That equates to -$74 on the straddle and $1,000 on the futures. It would still be a profitable idea, but we can see that theta is the enemy of anyone who buys options. Said another way, buying options to trade the delta can be successful, but it is an instant gratification idea.

Figure 7: Micro Bitcoin option straddle with theta decay

To subscribe to new issues of this report, visit cmegroup.com/excellwithoptions


The opinions and statements contained in the commentary on this page do not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs. This content has been produced by [Data Resource Technology]. CME Group has not had any input into the content and neither CME Group nor its affiliates shall be responsible or liable for the same.

CME GROUP DOES NOT REPRESENT THAT ANY MATERIAL OR INFORMATION CONTAINED HEREIN IS APPROPRIATE FOR USE OR PERMITTED IN ANY JURISDICTION OR COUNTRY WHERE SUCH USE OR DISTRIBUTION WOULD BE CONTRARY TO ANY APPLICABLE LAW OR REGULATION.

CME Group is the world’s leading derivatives marketplace. The company is comprised of four Designated Contract Markets (DCMs). 
Further information on each exchange's rules and product listings can be found by clicking on the links to CME, CBOT, NYMEX and COMEX.

© 2022 CME Group Inc. All rights reserved.