Dazed and Confused

So, the markets have been quiet for a session and unemployment statistics are about to be released. The markets trade in a range and are nervous about the release. Everyone is expecting a big move, and volatility has been on the increase for days.

Let's say that right now the long bond market is trading right at a strike price, 112. There are 56 days to futures options expriation and volatility is trading in the 13% range, up from 10%. Open interest is jumping and the public seems to be buying up lots of puts and calls.

So the number is released on Unemployment Friday. Given the last release, Non farm payrolls were far lower than expected. And the market moved in exactly the opposite way than expected, up instead of down.

The net delta of the at the money straddle is about 0. But when such a trade is purchased, it is anticipated that long deltas will be "created" on the upside at an increasing rate and short deltas will be created on the downside at an increasing rate. The delta is the approximate rate of change with respect to the underlying asset or liability. The rate of change at which the delta changes is called the net position "gamma". If the first partial derivative is the rate of change of an options price with respect to the underlying price is the delta, the second partial rate of change of that options price is the gamma.

The public is often suckered into buying such positions like straddles or strangles when antipating a big move in the market. But those who do so have tended to forget the adage, "buy the rumour, sell the fact". Even though someone might have purchased some bond options at a net straddle price of 1 4/64ths, that straddle may actually break even or lose money after the move! Why?

Because another sensitivity that people often forget about is called the vega, the rate of change of an options price with respect to volatility. After a big movem, the pit and instiututions will sell off premium, In addition, options are wasting assets. On a Friday, the pit will often, by the end of the trading session start trading the opeions as if they are pricing them on Monday morning! I've seen vol drop as much as 5% while a release is actually going on!

Take a look at the folllowing options pricing primer. The Black model (1976) correctly prices a futures contract in a Brownian Motion, reflecting a lognormal distribution. However the difference between a forward price and a futures price refects the daily margin account adjustment, forwards only expire at the end of a term.

http://riskglossary.com/articles/black_1976.htm