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January 1, 2014  Wed 7:41 AM CT

A recent email from a reader reminded me that it is useful to understand the mechanics of an option trade.

The note was in reference to a recent post on mining company Iamgold. The trade involved the purchase of 20,000 January 2015 3.50 puts for $0.80 and the purchase of 780,000 shares of IAG for $3.5313 shortly after. As I mentioned at the time, this is a delta-neutral position that could profit if the stock moves sharply higher or lower and/or if its volatility is greater than that implied by the put premiums.

The reader in question apparently didn't like what I wrote. Here is his email:
"You forgot to mention that someone SOLD all of those puts and is betting that the stock will stabilize or rise and all the sale $$ will go to the bank. Please learn more about options before posting garbage."
Let's examine the trade further to show why I wrote what I did. The delta of an option contract is its sensitivity to changes in the underlying stock price. The delta of the IAG puts was -0.39. This means that they theoretically would gain $0.39 for a $1 drop in the share price. So the total delta of the put position is -780,000 (-0.39 x 20,000 x 100). The purchase of that much stock makes the position "delta-neutral," as the trader is making a bet on higher volatility in this case.

As to the email, the writer is correct--sort of. When the institutional trader bought the 20,000 IAG options, the seller was a market maker. And that market maker will immediately hedge directional risk to become neutral. Market makers would usually look to sell those options to another party to eliminate that risk, but that's not always possible, especially with volume this big.

The really interesting part of all this is which side of the trade makes money. The answer is that they both can. This example is a bit unusual, because most option trades are outright buys or sells, but the theory remains the same.

Let's say the trader who opened the original IAG position is looking only for a big move in one direction or the other, and gets it. Then let's say that IAG goes back up to $8--where it was in late August--before that January 2015 expiration. The puts would expire worthless, but the stock gained roughly $4.50, so a huge profit is made.

One would expect that the trader on the other side--the market maker, in this case--must have lost money. But suppose the market maker was keeping his or her position delta-hedged, selling shares as they moved higher to keep neutral, and the overall volatility was lower than that implied in the options. The implied volatility of those puts is 57 percent, and if actual volatility is less than that, the market maker can profit. (The long-term historical volatility of IAG has been above 57 percent for the last six months but was below that level for the previous two years.)

So both sides of this trade can win--or lose, for that matter. And the note I received is a good reminder that option trading really is multi-dimensional and can be fined-tuned to one's outlook. It is also a good reminder that we should always keep ourselves in check to avoid such traps as "confirmation bias" and "the endowment effect."

(A version of this article appeared in optionMONSTER's Advantage Point newsletter of Dec. 18.)
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