Important Lessons From Last Week – Delta Hedging & Options

Last week was a good example of what can happen when price begins to fall through heavy put strikes and something that short term traders should be aware of even if they don’t trade options. Last week here, I posted the open interest for the start of the week which had a more bullish look to it. The assumption was that price would stay above the heavy strike puts by the close of the week, especially cause price was already near 210 at the start of the week. Here is what it looked like Monday morning of last week after SPY closed Friday at 209.62: spyspy

As the week progressed , I posted this update on both Twitter and StockTwits which showed that more puts were piling in and at lower and different strikes.

Here is what I wrote on Thursday: Screen Shot 2015-12-12 at 7.42.11 AM

Last week was a very choppy bearish biased trade for most of the week, but price was trying to hold over 205 right where there was a line of heavy put strikes. It was doing a decent job until Friday. As I wrote above, delta hedging is usually the exception rather than the rule, but it’s a very under discussed topic that can have significant impact on stocks. The last time it happened was OPEX week this past August, the week the market was in free fall. Typically, but not always, when delta hedging leads to a fast and heavy sell off, it happens toward the end of the week. In August it began Thursday.

Here is a post I wrote in August of 2013 that describes the mechanics of delta hedging. For a refresher, here is a quote taken from a post written by Todd Salamone  (@toddsalamone) in 2012:

Or was last week’s price action driven in part by a delta-hedging decline related to the huge build-up of put open interest on major equity indexes and exchange-traded funds (ETFs)? As popular put strikes were violated one after another during expiration week, sellers of the puts may have been forced to short futures to keep a neutral position, creating a steady but sure stream of selling. The heavy put open interest strikes essentially act like “magnets,” as one strike after another is taken out. Delta-hedging risk certainly grows during expiration week if the market gets off to a weak start, as it did last Monday, and there is heavy put open interest just below current prices. 

Think “dominos” to help picture what happens. Note that this can happen to the upside with many call strikes as well. 

Friday’s sell off didn’t begin because of the open interest and delta hedging necessarily. The upcoming FOMC, the price of oil, junk bond risk, and tax selling were the larger culprits that began the selling. It was delta hedging that made the selling so much more heavy and swift. The reason this is an important concept to understand is it can help you from catching falling knifes and possibly to profit if you see it coming. When the open interest is heavy with puts and especially when it’s late in the week, once that first strike is breached, technical support becomes less important. If on top of that their is negative breadth that is trending further down (as there was on Friday) it should act as confirmation that there is high potential for a much faster and heavier move than a typical trending down day.

Here is a closer look at what open interest looked like coming into Friday’s session. Notice the 209 puts that were added in Thursday’s session. Opening below them already put SPY in the position of a possible move lower, but what really made it worse was opening below 205 on Friday. spyspy

To learn more about using open interest to trade SPY and individual stocks check out my premium service.

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