From time to time, options spread traders need to trade high delta instruments. Whether it is a tactical trade to capture a sharp move in the underlying, or a last minute defense at expiration, the way a trader buys or sells large deltas contributes greatly to the ultimate profit or loss in an options position.
Because high delta spreads and combinations tends to approximate the profit / loss profile of unhedged long or short stock, I like to categorize high delta positions as stock equivalents.
The most obvious way to generate a high delta position is to buy (or sell short) the underlying stock itself. Common Stock usually has greater liquidity and lower bid/ask spreads than listed options, which is a plus. On the downside, the capital requirement is 16% of the stock price in a professional market maker JBO account, or more typically, 50% of the stock price in a Regulation T account. Under Regulation T rules, a 250 dollar stock requires 12500- minimum haircut to hedge a single options contract. There is also the risk of a margin call intraday if the stock makes a move in the wrong direction.
The situation becomes more complicated when selling short. Not only must the trader take into account the margin requirement, but also the borrow status of the underlying — Easy To Borrow, Hard To Borrow, Impossible To Borrow. The borrow status can and does change, and when it does, the trader is subject to buy in risk, which occurs when there is no stock available to borrow and the financial custodian buys back the shorted shares. Your author had a clearing account at Goldman Sachs during the 2008 Financial Crisis, and everyone was acutely aware that if a buy in occurred, it would be overnight, at the Goldman price. A sobering thought, to say the least.
One solution to the hard-to-borrow / impossible-to-borrow situation is to combine long stock with an options position. Conversions and deep in the money long stock + long put positions are two possibilities. Options market makers and institutional traders at stock loan desks often employ these strategies to acquire an inventory of long stock, or at a minimum monitor the conversion price vs. the reversal price to estimate the cost of synthetically shorting a hard or impossible to borrow issue. In certain emerging market exchanges, short selling itself is banned and synthetic shorting techniques are mandatory to capture downward movement in a stock or futures contract. If puts are not available, selling deep in the money calls becomes an effective surrogate.
Options spread and combination traders have even more flexibility using stock equivalents. One recent example occurred during the recent wild oscillations in 3x Levered ETF Gold Miners (NUGT and JNUG) and 3x Levered ETF Russian Stock Index (RUSL and RUSS). The SpreadHunter trading team took positions in long strangles in weekly options at the beginning of the week. When the underlying made a huge move in either direction, going into the money on either the put side or call side, instead of selling out the long option for a profit, the traders sold in the money options one, two or three strikes deeper in. This not only locked in profits on one leg of the strangle, but created a synthetic vertical spread position for very low cost. This nuance proved to be highly profitable when the ETFs reversed direction and the opposite leg of the strangle and the bearish spread position kicked in.
David A. Janello, PhD, CFA