Amazon Stock Split steals the show from Apple. Is AMZN ready to become the largest single stock options trade?
Amazon’s 20-for-1 stock split was executed on June 6, and the stock is trading higher as a result. But why? Don’t stock splits make sense?
The answer is more complicated than you think — especially if you are an options trader.
Let’s take a look at the different ways the Amazon split will affect the options market.
Cheaper to cover an investment
When Amazon (AMZN) – Get the report from Amazon.com, Inc. revealed for the first time that they were splitting their shares, Market Rebellion co-founder Pete Najarian pointed out some of the advantages this decision could have for traders and investors looking to hedge their positions.
“[Stock splits] open derivatives markets. Something that was a $50 option that someone probably couldn’t trade, can now be purchased at a much lower cost. And along the way, you can hedge against the downside, or you can do something about the upside.
This means that traders who are long on Amazon shares will have a much easier time using options to mitigate risk on their position. The options offer several ways to do this.
Most commonly, traders can use covered calls to collect option premiums on a stock of which they hold at least 100 shares. On the Friday before the split, 100 shares would have cost $244,700. Now compare that quarter million dollar investment to a split adjustment of $12,235!
Covered calls aren’t the only hedging strategy that benefits from a split. As Pete said in the clip above, options themselves are much more affordable, which means investors will have a much easier time using long puts and short call spreads to protect their investment.
Pete Najarian uses covered calls to hedge his investments. Find out how with Covered calls from Pete and discover the strategy used by professional traders to defend their long-term stock portfolio.
Easier to become aggressive
In the section above, we explain how Amazon’s stock split facilitates investors to play defense with options. But there is a flip side to this coin – traders use these reasonably priced options to play offense. And on Monday, Market Rebellion’s Heat Seeker algorithm spotted a trader doing this the BIG way.
Jon Najarian spoke about this massive exchange of calls in today’s edition of CNBC half time report.
“This morning 35,000 of the $130 weekly calls were bought in a huge block. This therefore makes 3.5 million equivalent shares. It’s not just that people have more access to stock, but also to these options, which are exploding. The volumes there will be quite indicative of the future destination of this stock.
These calls would have have been on the $2,600 strike, and would have cost between $22.00 and $38.80 per contract. This multi-million dollar purchase ends the narrative that Amazon’s stock split is “important only for retail traders”.
Amazon steals the show from Apple
It’s not just the price of options that are directly affected by the split. It is also about liquidity. Before the Amazon split, the reigning king of options volume was Apple (AAPL) – Get the Apple Inc. report.. But now that open interest from Amazon has been multiplied by a factor of 20, the e-commerce giant is poised to challenge defending champion Apple for the title of highest single-stock options volume.
This is evident when you look at Monday’s huge options volume gap – 2.611 million contracts traded on Amazon, eclipsing Apple’s 959,000.
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Increased volume has a number of cascading effects in the options market, such as tighter bid/ask spreads that provide traders with better order execution. But more importantly, when options volume begins to increase, implied volatility often increases along with it, resulting in greater extrinsic value in the contract price.
In short: High volume is another factor that can drive up option prices.
How Stock Splits Affect Delta and Gamma
We’ve explained how the Amazon split has the potential to increase volume and subsequently implied volatility – but there are two other options metrics that stock splits have a big effect on: delta and gamma.
Option Greeks are measurements that determine the value of an option. Without getting too deep into the subject, let’s quickly define these two Greeks.
- DELTA: The rate of change in an option’s premium per $1 change in the underlying asset. Calls have a positive delta, puts have a negative delta.
- GAMMA: The rate of change of an option’s delta with each $1 movement in the price of the underlying asset.
To put it another way, delta is like the the rapidity of an option’s price change, and the gamma is like acceleration a change in option prices.
But how do stock splits actually affect these metrics, and what does that mean for option holders? Let’s take an example to find out.
Imagine you hold a $AMZN call option at the money at the strike price of $2,500, before the 20:1 split, with a delta of 0.50.
What happens to the delta when you maintain the 20:1 split? Now you have twenty exercise calls at $125, all with a delta of 0.50. So even though the individual deltas haven’t changed, your total delta has increased twenty-fold, from just 0.50 to 1,000! This means that after splitting, the options in question are twenty times more responsive to a $1 change in stock price.
Of course, there is a counterweight to this — the stock price is reduced twenty times! Despite the fact that a dollar change means a lot more for the option in question, it’s always the same thing from one percentage base.
Still, this substantial change in total delta can make a huge difference to option holders, and it’s an important metric to watch.
The effects of a stock split on an option range are even more pronounced. Let’s go back to the example above: our call option at the $AMZN parity, to find out why.
In the example, imagine that the $2,500 at-the-money strike call option has a gamma of 0.002. This means that if you have a delta of 0.50 and the stock goes up $10, your option will gain two deltas, bringing your total delta to 0.52! It is the same in reverse. If the stock drops $1, you lose two deltas and you now have a 0.48 delta option!
But now you have a 20:1 split to consider: what happens to your option gamma?
You have twenty call options, at a strike price of $125, and the gamma is multiplied by twenty, which means that the gamma is now 0.04 for each option. So now you have twenty times the options and twenty times the gamma (from 0.002 pre-split to 0.8 post split), leading to an overall 40x increase in gamma!
In short, this means that options held through the split are ultimately more sensitive to changes in the stock price due to the effects caused by gamma amplification.
Amazon’s equity division presents increased opportunities for options traders. Cheaper options mean more opportunities for traders to be bullish and bearish exposure to Amazon. More opportunities for investors to hedge their positions. Higher liquidity and, potentially, higher implied volatility at the same time.
Hear what Jon and Pete had to say about the split and the unusual optional activity that came with it in today’s edition of Rebel’s Edge.
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