Stocks sometimes gap up in opening trade. If you anticipate such gap-ups, how should you position your derivatives trade? This week, we discuss a setup to take advantage of such price gap-ups.
Intrinsic value capture
A gap-up is when an underlying opens and trades above the previous day’s high. Note that the Black-Scholes-Merton (BSM) model cannot reasonably value options when an underlying price gaps up. This is because the model assumes that the change in an asset price is always small.
Now, a call option’s price will increase if the underlying moves up. This increase can be attributed to delta of the option, which is the change in option price for a one-point change in the underlying. That means, the greater the delta of an option, the better the gains if the underlying moves up. This suggests that buying an in-the-money (ITM) call with greater delta would be meaningful. But such options may not be liquid. And liquidity is important to close a position and take profits when you are trading European options.
As traders, you must trade off potential liquidity and expected gains. Therefore, the optimal choice would be to buy at-the-money (ATM) option. This option has zero intrinsic value and the greatest time value among all the options. When a stock gaps up, the ATM option becomes ITM. Suppose the stock moves from 500 to 550. The 500-strike option would have 50 points of intrinsic value. Note that intrinsic value of an option moves one to one with the underlying. If you are betting on a gap-up in the underlying, it is highly likely that you will close the position immediately after the event. Therefore, the loss in time value of the option (time decay) will be minimal. Hence, the option will generate handsome gains if your bet turns correct.
If you are confident of a price gap-up, you could consider buying futures on the underlying, as futures move almost one to one with the underlying. Sometimes, traders bet on a gap-up based on how a stock moves towards its resistance level. But what if the stock fails to break above the resistance level? Therefore, trading ATM options may be optimal for such aggressive bets.
Optional reading
ATM options have the greatest gamma. So, the change in delta is the highest for the ATM strike for a given change in the underlying price. It is possible for a stock to gap up and continue trending upwards. If you intend to hold your option position after a stock gaps up, you should take profits before the ATM strike becomes deep ITM, as liquidity will decline when intrinsic value increases. Note that trading options to bet on price gap-ups is positioned to capture intrinsic value without much loss in time value. That is why buying an out-of-the-money strike may not be optimal — not only will such strikes carry zero intrinsic value even after the underlying gaps up, the change in delta will be small too.
The author offers training programmes for individuals to manage their personal investments