Hey Traders,

Wednesday was definitely an interesting day on the market.

There is no doubt about that … with the Dow Jones Industrial Average (Ticker: DJIA) falling 1,100 points – its worst day since June 2020.

And the S&P 500 (Ticker: SPX) dropped 165 points … more than 4%!

But headed into Wednesday’s trading session, there was actually another unusual setup I had my eye on …

With VIX options expiring Wednesday morning, I was watching some telling action in the VIX pits …

Delta measures how an option’s price will move for every $1 change in the underlying – so an option with a delta of 50 will gain $0.50 or lose $0.50 for every $1 up or down the underlying moves.

Deltas range from 0 to 1.00, but typically are referred to as a whole number integer – so a delta of 0.25 is often called a “25 delta.”

Calls have positive delta, ranging from 0 to 1.00 – so the value of a 50 delta call would rise $0.50 if the underlying rises $1, and it would fall $0.50 if the underlying falls $1.

Puts have negative deltas, so a put with a delta of -50 will lose $0.50 if the underlying rallies $1, but gain $0.50 if the underlying falls $1.

Short puts and short calls, however, will have the opposite delta – and that is why some traders will use short or long options (or equities!) to balance the delta of a large trading position. You can get a rundown of delta neutral trading right here.

Now, one thing that is important to know is that the deeper in-the-money an option gets, the closer to 1.00 (or -1.00) the delta, with at-the-money calls and puts typically having a delta of about 0.50 or -0.50.

(One interesting dip about an option’s delta: it can be used as a very loose, “rule of thumb” estimation of the chances that an option ends up in the money (ITM). So an at-the-money call with a delta of 50 has about a 50% chance of ending up ITM!).

Take a look at the deltas of the AAPL options below, and note how the ATM 141-strike calls and puts both have a delta of 0.50!

Now, as time passes, and options near their expiration, their delta shifts.

In-the-money options will usually see their delta increase as expiration gets closer, while out-of-the-money options will often see their delta decrease.

And this can have some interesting implications …

For example, we just saw VIX options expire yesterday morning (though they stopped trading Tuesday at the close).

Now, there was some pretty substantial downside put open interest (keeping in mind the VIX closed at 26.10 on Tuesday).

Headed into expiration, the traders that were short these puts started to see the delta of these short puts (which, recall, have a positive delta, rather than a negative delta like a long put) fall.

And a lot of these same dealers were likely short VIX futures, as well, because by shorting futures and shorting puts at the same time, they’re able to neutralize the delta of their positions, as the short futures will have a negative delta, and the short puts will have positive delta.

However, as the delta of the short puts start to fall, the traders will find that they now – often quite suddenly – have too much downside delta exposure from their short futures.

The result?

They need to repurchase their short futures positions.

And unlike equity options, which can be assigned at expiration, VIX options are cash settled.

So when traders wake up and discover that their delta has gotten out of control, they need to act quickly to avoid some what could be some major consequences.

That is what we saw headed into this past VIX expiration …

And if we see a similar build up of puts over the next few weeks, we may see it again soon.

Your Only Option,

Mark Sebastian