Introduction: The Ever-Evolving World of Options Trading

Options trading is a fascinating yet intricate landscape where even the most seasoned traders continually learn new strategies and jargons. Among the nuanced concepts are “sticky strike” and “sticky delta,” terms that describe how options prices change when the underlying asset moves.

Understanding these ideas can significantly affect your trading strategies. This comprehensive guide aims to demystify these terms, break down their meanings, and explain their implications on options trading strategies — all simplified with easy-to-understand examples.

Table of Contents

1. Sticky Strike
2. Sticky Delta
3. Implications for Trading Strategies
4. Case Studies and Examples
5. Conclusion: Why You Should Care

What is Sticky Strike?

The term “sticky strike” refers to a situation where the implied volatility (IV) of an option remains constant for different strike prices, even as the price of the underlying asset changes.

What Does it Sticky Strike Mean?

Imagine you have a call option for stock XYZ with a strike price of $50, and the stock is currently trading at $50. Now, let’s say the stock price rises to $55. In a sticky strike scenario, the implied volatility for your option with a $50 strike will remain constant, even though the stock price has moved.

Why Does it Matter?

The stability of implied volatility across different strike prices aids traders in comparing various options more straightforwardly. However, the sticky strike assumption is more of a theoretical construct than a consistent market reality.

2. What is the counterpart of sticky strike: Sticky Delta?

Definition

Sticky Delta, or Sticky Moneyness, implies that the implied volatility will adjust so that the Delta of the option remains constant even when the underlying stock price changes.

What Does it Mean?

Consider you have a call option on stock XYZ with a Delta of 0.5 when the stock is at $50. If the stock price moves to $55, the implied volatility will change in such a way that the Delta remains at 0.5, hence “sticky” Delta.

Why Does it Matter?

Sticky Delta is useful in understanding how the option’s sensitivity to the underlying stock will change, particularly during large price swings. This concept becomes increasingly important for traders who use Delta hedging as part of their strategy.

The Sticky Strike Rule:

Some market players believe that when the stock/index moves, the volatility skew for an option remains unchanged with the strike. This behavior is referred to as the sticky strike rule. The rule is applicable when the markets are expected to be range-bound in the near future without significant changes in realized volatility.

The Sticky Delta Rule:

There are some market players that tend to believe that the volatility skew remains unchanged with moneyness. For example, let's say that the implied volatility for an ATM option is 30% with the index level being at 100. Now if the index declines to 90, this rule would predict that the implied volatility for 90 strike option would now be 30%. Hence the behavior is known as sticky moneyness or sticky delta.

The sticky delta rule is more applicable when the markets are trending without a significant change in realized volatility.

Figure 1 below shows figuratively how the volatility skew gets affected under the two rules. If the current level of the underlier was S0 and the volatility skew for a specific tenor was indicated by L0. Under the sticky strike rule, the skew remains the same L0. Under the sticky delta rule, the skew moves in the direction of the underlier move. Thus when the underlier moves from S0 to S1, the new skew is indicated by L1.

figure 1:Volatility skew as the market moves

Both the sticky strike and sticky delta rules have been proven to provide arbitrage opportunities. However, these rules do help us understand the risks of the traded products.

It is known that when the market falls, the implied volatility is observed to increase. E. Derman describes a sticky implied tree rule which is consistent with this observation and is also argued to be arbitrage-free.

3. Implications for Trading Strategies

Understanding whether the market is behaving in a Sticky Strike or Sticky Delta manner can significantly influence your trading decisions.

a. For Sticky Strike:

Long-term Strategies: This behavior is commonly observed for long-term options, making it valuable for strategic trades involving leaps (long-term options).

Traders can more easily compare options with different strikes but similar expiration dates.

b. For Sticky Delta:

Dynamic Hedging: Traders using Delta-hedging strategies need to monitor Delta regularly, especially in volatile markets.

Risk Assessment: Knowing that Delta is sticky can help in more accurate risk assessments when planning options and strategies involving multiple variables.

4. Case Studies and Examples

Example 1: Sticky Strike in Action

Let’s say you own a call option of XYZ with a strike of $50 and an implied volatility of 20%. The stock rises from $50 to $55. Despite the increase, the implied volatility of your call option remains at 20%. This is a classic example of a sticky strike scenario.

Example 2: Sticky Delta in a Volatile Market

Suppose you own a call option of stock ABC with a Delta of 0.5. The market is highly volatile, with ABC swinging between $40 and $60. If your option’s Delta remains at 0.5 throughout these swings, you’re witnessing Sticky Delta in action.

5. Conclusion: Why You Should Care

Sticky Strike and Sticky Delta are nuanced but essential concepts in options trading. They affect how you monitor your positions, how you hedge your risks, and even how you plan your entry and exit strategies.

By understanding these terms, you elevate your trading acumen, enabling you to adapt and refine your strategies for various market conditions.

While no single model is perfect, being familiar with these ideas can provide you with a more comprehensive toolkit for tackling the ever-evolving world of options trading.

Whether you’re a casual trader or someone making a living in the options market, knowing the ins and outs of Sticky Strike and Sticky Delta is invaluable. So the next time you find yourself puzzled by how an option’s price is behaving in relation to its underlying stock, take a moment to consider whether you’re in a Sticky Strike or Sticky Delta environment — it could very well make or break your trading strategy.