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Delivering Delta Neutral

Published in Automated Trader Magazine Issue 15 Q4 2009

Joseph Corona, Director of Strategic Planning at ConvergEx’s LiquidPoint, profiles a volatility trade executed using an advanced option execution algorithm capable of handling both the option and stock legs of the trade simultaneously. 

The Scenario: It is early June 2009 and a trader at a mid-sized US proprietary trading group is scanning the market for possible volatility trades. The trader's attention is drawn to a significant patch of resistance in Google's stock price around 444-449 (see Figure 1). Google failed to break through and close above this region during an abortive rally in the long downtrend in late 2008. This is also the first time Google has approached this zone (which also represents the top end of the Market Profile value area for September 2008) since then.

The trader's expectation is that as Google moves into this congestion zone the implied volatility in the nearest out of the money call strike will soften as the stock slows up. However, if the stock fails at this level it is likely to pull back sharply and implied volatility will rise. On the other hand if it manages to break through the congestion, there is a good chance that it will move up sharply away from the strike, making the position profitable as the next significant resistance is around 500, which is top of the Market Profile value area for Aug 2008.

The trader's assumption is that given the strength of the resistance any pull back or break out would be likely to persist strongly for perhaps two weeks or more. The trader expects volatility levels to hold up into the July earnings time frame, and will be looking to generate some "gamma scalping" profits from rebalancing the portfolio before exiting the position in early July, ahead of earnings (and the usual post-earnings implied volatility meltdown). In view of this thought process, and the desire for optimal "gamma firepower" into the early July time frame, the trader opts for the July expiry and in view of the resistance zone's location, the trader decides to buy the 440 calls.

The Asset: Google call options and Google stock. Bid ask spread for the stock typically fluctuates around .10 and thirteen week average daily volume (ADV) is approximately 2.8m. Bid/ask spread for the nearest out of the money call is .30 and average daily volume for that strike is approximately 600 calls, 200 puts.

The Challenge: To buy 400 contracts of Google July 440 calls while simultaneously matching this with a delta neutral short hedging position in Google stock by the end of the trading day.

The Algo: The liquidity seeking algo the trader intends to use allows anonymous access to additional liquidity on a specific major liquidity network while also representing the order on all seven exchanges, and - if applicable - exchange complex order books as well. In addition, the algo is able to:

• Work limit orders dynamically adjusted by a user-specified relationship to the stock price (also known as "Volatility" or "Delta" orders).
• Automatically delta hedge any option executions that occur.
• Specify levels or bands in which the order is valid.
• Work concealed, displayed, or partially displayed.
• Operate with a specified "run time" for the order.

The Trader: The trader, who is based in Chicago (all times below in Central Daylight Time), handles the bulk of the proprietary trading group's options activity. She has a preference for support/resistance volatility trades and makes extensive use of Market Profile and a proprietary methodology based on volatility cones1 and congestion count2.


Figure 1

Figure 1

Source: CQG, inc. © 2009. All rights reserved worldwide. www.cqg.com

7.30am: After a steady uptrend since late May that has culminated in two strong up days, Google is immediately below the resistance zone and also significantly overbought as measured by most conventional oscillator indicators. The trader therefore suspects that while Google may open gap up again it may then start to stall. She therefore intends to stand aside during any opening volatility rush and only set the algo running once the stock is trading back within the volatility cone and with a sufficiently high congestion count.

8.30am: Google gaps up as expected straight into the resistance zone. It immediately slips back, but then recovers and moves above 447.

8.46am: The stock has slipped back towards the lower edge of the resistance zone. It is now trading within the volatility cone and has also reached an acceptable congestion count level (see Figure 2). The gap up on a Friday has resulted in a nice decline in implied volatility levels and the trader is satisfied with the general level of the implied volatility midpoint near 34% and would like to begin the process of acquiring 400 options worth of synthetic long straddles near this level. A liquidity seeking order is launched to buy 400 July 440 calls at 22.90 on a 55 delta versus stock at 445.00. To avoid negatively impacting offers, the order is launched anonymously into the liquidity network, as well as across all 7 exchanges, in hidden mode. Matches that occur in the liquidity network are executed as Solicitation crosses in the CBOE's AIM mechanism. Executions begin to trickle in and the trader quickly acquires 80 calls at an average price of 23.47 against 4400 short stock at an average price of 446.05.

Figure 2

Figure 2

Source: CQG, inc. © 2009. All rights reserved worldwide. www.cqg.com

9.01am: Google has broken out of its vol cone and the congestion count has also fallen below the threshold. The trader temporarily suspends the algo. Implied volatility jumps on the breakdown and the bid is now above the desired target levels. The trader cancels the order and is looking to re-enter on consolidation. With the stock taking out both the opening and the low the trader is cognizant of the fact that a technical failure may be setting up and she may have to get a bit more aggressive in terms of volatility
levels as the day progresses.

9.04am: Google now trading back inside the cone and congestion count has also recovered. Still sensing the possibility of a technical failure, the trader is now willing to buy volatility at a slightly higher level with the following parameters: Buy 200 July 440 calls at 21.90 on a 53 delta versus stock at 443.00. The order will now be sliced and smart routed to the exchanges and the complex order books fully exposed. In addition, a stock contingency of 446.00 or lower is placed on the order as a rally above that level may negate the possibility of a technical failure and implied volatility could drop further.

9.43am: For much of the past forty or so minutes Google has stayed in a tight trading range, allowing a significant amount of the position to be accumulated. A total of 160 more contracts are purchased at an average price of 22.10 versus 8480 short stock at an average price of 443.11. The overall position now stands at 240 long July 440 calls versus 12,880 short stock.

Figure 3

Figure 3

Source: CQG, inc. © 2009. All rights reserved worldwide. www.cqg.com

10.30am: The Market Profile control point has just dropped slightly again (see magenta highlight in Figure 3) but the market is still trading near the centre of the current volatility cone. The trader takes the view that the rather noisy downtrend since the open will probably persist for a while yet, albeit at a fairly leisurely pace. The trader cancels the order hoping that midday consolidation and the Friday effect will take implied volatility lower.

11.10am:
The downtrend has accelerated and Google has broken sharply below its current volatility cone and recent congestion dissipates. There is a real concern that volatility will pick up with a significant decline into the afternoon session. The trader is still hopeful for a Friday afternoon markdown in implied volatility, but is getting nervous. With displayed liquidity on the light side midday she launches an order into the liquidity network with the following parameters: Buy 160 July 440 calls at 20.75 on a 52 delta versus stock at 441.00. She intends to work this order into the afternoon so she specifies a 110 minute run time.

Google: Implied Volatility and Price

Google: Implied Volatility and Price

11.29am: Google staged a sharp rally starting at 11.23am, but is now drifting back into the centre of the current volatility cone. No further executions have been received but bid-ask spreads are drifting lower.

11.45am:
The past fifteen minutes have seen the congestion count reach a significant intraday high of 16 (on a one minute chart) as the market has stayed largely range bound around 441. Partial executions are beginning to come in. A total of 40 calls are purchased at an average price of 21.03 versus 2080 short stock executed at an average price of 441.54. Total position now stands at 280 long July 440 calls versus 14,960 short stock.

11.48am:
Market has rallied outside cone and congestion count has collapsed.

11.54am:
Rally continuing.

12.06pm:
Market now easing off

12.30pm: Another partial execution of 50 calls at an average price of 21.76 versus 2600 short stock at an average price of 442.95 is achieved as volatility eases while the market tracks sideways. Total position now stands at 330 long July 440 calls versus 16,940 short stock.

Google: Historic Volatility

Google: Historic Volatility


12.40pm: Rallying outside cone. No further fills are received and the order stops running at 13:00 with the expiry of the 110 minute time limit the trader specified at 11.10am. With the market rallying on a Friday afternoon the trader is relaxed about the prospects of executing the remainder of the strategy. She places the following order: Buy 70 July 440 calls at 21.80 on a 53 delta versus stock at 443.00. The order will once again be sliced and smart routed to the exchanges and the complex order books fully exposed.

13.50pm:
Lunchtime inertia ends with a strong up bar (on a one minute chart)

14.05pm: The Market Profile control point has just moved up for the first time today; not an auspicious sign - especially if the day traders who went short earlier in the day all rush for the short closing exit at the same time. A fill is received from the ISE complex order book for 35 calls at 22.40 versus 1855 short stock at 444.14. Total position now stands at 365 long July 440 calls versus 18,795 short stock.

14.16pm:
Market appears to have found a new point of equilibrium just above 443

14.32pm: More bad news; break out above the cone.

14.37pm:
Rally persisting, approaching 445, volatility is increasing and time is fast running out. The trader has received no further fills in the displayed market and decides to source additional liquidity in the liquidity network. The working order is cancel/replaced and directed back into the liquidity network anonymously at a higher level. The following order is placed: Buy 35 July 440 calls at 22.90 on a 55 delta versus stock at 445.00.

The order fills quickly, buying the last 35 calls at 22.98 versus 1925 short stock at 445.15. The total position is now 400 long July 440 calls at an average price of 22.32775 versus 20,720 short stock at an average price of 443.8172. Done…

14.53pm: …fortunately, because after the recent decline, Google is now rallying back into the cone…

15.00pm: …and continues to rally firmly in to close at 444.32…