Short Strangle After a Takeover Gap
Your desk has sold 200 lots of a stock-option strangle on PQR Ltd, with each lot representing 250 shares. The position is short 200 lots of the 1,250-strike call at an average premium of ₹18 and short 200 lots of the 1,150-strike put at ₹22. At initiation, PQR traded at ₹1,200 and 30 days remained to expiry. Overnight, a strategic buyer announces a 30% open offer at ₹1,390. PQR opens at ₹1,380 and is locked in a 10% upper circuit; the stock futures trade at ₹1,395. Implied volatility on the 1,250 call jumps from 28% to 52%. Your SPAN margin plus exposure is estimated at ₹3.2 crore against collateral of ₹2.4 crore, but the exchange's peak-margin requirement may rise. The options are American-style and physically settled. The desk's risk limit for net delta is ±20,000 shares.
1. Calculate the intrinsic-value mark-to-market on the short strangle and explain why the loss is not limited to that figure.
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The position is short 50,000 shares equivalent (200 lots × 250). Call intrinsic at spot ₹1,380: 1,380 - 1,250 = ₹130. Loss on the short call = (130 - 18) × 50,000 = ₹56,00,000. Put intrinsic: spot is above 1,150, so intrinsic is zero; the short put retains the ₹22 premium received, a gain of 22 × 50,000 = ₹11,00,000. Net intrinsic loss = ₹45,00,000.
The mark-to-market loss will be larger than ₹45 lakh because both options still have time value and implied volatility has risen to 52%. The short call is deep in-the-money but still carries time value; the short put also gains value from higher volatility even though it is out-of-the-money. The desk is short vega and short gamma, so the loss accelerates if PQR moves further or volatility stays elevated. Margin will also rise, and the collateral shortfall of about ₹0.8 crore must be funded.
2. What hedge would you put on, and what are the residual risks?
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Estimate the current deltas. The 1,250 call is deep in-the-money; assume delta about 0.75. Short call delta = -0.75 × 50,000 = -37,500. The 1,150 put is out-of-the-money; assume delta about -0.15. Short put delta = +0.15 × 50,000 = +7,500. Net delta is about -30,000 shares, outside the -20,000 limit. To reach the limit, buy at least 10,000 futures; to neutralize, buy about 30,000 futures at ₹1,395.
A practical hedge is to buy 20,000-25,000 PQR futures, bringing net delta inside the limit without fully locking in the loss. Residual risks remain significant: negative gamma means delta changes quickly, short vega means further volatility spikes hurt, and the futures trade ₹15 above spot, creating basis risk. The short call may be exercised early because it is deep in-the-money and the option is American-style; physical settlement would require delivering shares. The desk must also monitor circuit-locked conditions, because futures may be the only executable hedge.
3. What operational actions should the desk take before expiry or assignment?
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First, confirm the margin shortfall and arrange collateral immediately; do not wait for a margin call. Second, monitor early exercise of the 1,250 call. A deep in-the-money American call is likely to be exercised early if there is dividend or if the time value is small, so the desk should either buy back the call, roll it up, or ensure it can borrow or buy shares for physical delivery. Third, reduce the short strangle before expiry to avoid pin risk and assignment uncertainty. Fourth, keep the futures hedge dynamic; do not assume a static delta hedge will hold through a takeover-driven gap. Finally, document the hedging decisions and client/desk approvals, because the position may breach risk limits intraday if PQR moves further.