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The Invaluable Understanding of Delta, Part II

By Chris Rowe May 9, 2007 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Hello, Tycoons!

Last Thursday in an article titled "The Invaluable Understanding of Delta", I tried to teach you about the importance of understanding “delta” when trading options.  I decided to split the article into three parts for a couple of reasons:

  1. To give you time to digest the first part of the article.  If the word “delta” was new to you, or if it’s something that you had minimal knowledge about, then I felt that understanding it is so important that you should have a week-long break between the articles.  This way you've had a chance to review it, digest it, and maybe even observe how a few different option contracts traded with this new understanding.
  2. I was just sick of typing (JUST KIDDING).  Number one pretty much covers the reasons:  Review and digestion of info.

One thing that I want to discuss is the fact that there are so many options on one stock that expire in one particular month that it may be easy to misinterpret what I was saying last week about what you should do. 

I told you that by purchasing deep in-the-money options, you give yourself a high delta, resulting in an option that moves up in value more (point wise) than an option with a low delta as the stock trades deeper and deeper in-the-money.

That is all true.  For example, if XYZ trades at $50.00, the April $45.00 call option will move up more (point wise) than an April 50 call.

So, the deeper in the money you go, the more the movement in the stock’s price will be reflected in the option’s price.  But that works on both sides, which is why you don’t want to go too far in-the-money.

You have to have a balance between buying deep in-the-money calls, and still staying relatively close to the strike price, because if you buy a call that is too far in-the-money, you can not only make 98 cents on a 1-point gain in a stock, but you can lose 98 cents on a 1-point loss in the stock. 

You want to enjoy the benefit on BOTH sides of the trade.

What you want to do is position yourself so that if the stock moves up several points, 85-90% of that gain will reflect in the price of your call option, but if it moves down several points, you only want more like 50 or 60% of the loss reflecting in your option.  How do we do this?

When I buy a call or a put option to open a trade (which is the most basic form of options trading), I usually buy an option that is anywhere from being 2-5 series in-the-money, depending on how volatile the stock’s price is, and therefore how much time value the option on the stock has.  Usually the option that I buy will have a delta of about 0.75-0.85.

For instance:  Let’s say that I wanted to buy call options on Exxon Mobil (this is not an actual recommendation) when the stock was trading at $71.00.

If I decided to buy the call options which expired in April, the part of the option chain that I would focus on would look something like this:

                  EXXON MOBILE IS AT $71.00

Option

Price

Time Value Portion of Call

XOM April 60 call

$12.00

$1.00

XOM April 62.5 call

$9.90

$1.40

XOM April 65 call

$7.80

$1.80

XOM April 67.5 call

$6.10

$2.60

XOM April 70 call

$4.60

$3.60

The April 70 calls would be one series in-the-money.  The April 67.5 calls are two series in-the-money.  The April 65 calls are three series in-the-money, and so on.

SIDE NOTE FOR LATER: Notice that the April 70 call, which is almost at-the-money (only one point in-the-money,) is at $4.60!  That is why you don’t want to be too far in-the-money.  If the stock trades down, you want to retain some value in your option.  You want the “shock absorber” that comes into play when the option moves closer to the strike price, because that is when the delta moves down faster.

Since the delta of the call option is moving down as the stock moves lower, that means the stock will have less of an effect on the option, which is good if the stock is losing value.

The idea is to buy an option that:

a)     Has little extrinsic value (aka time value)

b)     Will still give you a decent return

c)     Has at least six months left before expiration

Why?

  1. The less time value that you have, the less money is at risk of time decay as the option approaches expiration.
  2. Using an extreme example:  You can essentially eliminate time value by buying a call option which is SUPER deep in-the-money like the Exxon Mobil January 20 call option (which would be 51 points in-the-money.)  But you wouldn’t want to do that because if Exxon moved 5 points higher, you would only make about 5 points on your 51 (Less than 10%.)  I guess you could do that, but that doesn’t excite me. 

    At the same time, since the stock’s price is so far in-the-money, the delta will remain high (near 1.00) even if the stock was trading lower (which means your option is losing very close to the point amount that the stock is losing.)

    That is a key point that I am trying to make.  I explained in The Invaluable Understanding of Delta 1 that you actually have less downside by trading options as opposed to stock when you trade with a higher Delta.  But it is important to understand that as your option becomes too deep in-the-money, the reduction of risk (when compared to stock) lessens. 

    I’ll explain:

    If you were to buy the Exxon Mobil January 20 call option (51 points in-the-money) when the stock is at $71.00, and then the stock traded down 20 points, then the call option would trade down almost 20 points (over 19 points.)

    The idea is to buy options that are in-the-money, but still relatively close to the strike price.  Again, I like to buy 2-5 series in-the-money. (In Exxon Mobil’s case, I would buy the April 62.5 calls at $9.90)

    Why?  The Exxon Mobil calls are $8.50 in-the-money (stock price of $71.00 minus the strike price of 62.50 = $8.50.)  That means that within the option’s price of $9.90, $8.50 is intrinsic value (which is not affected by time decay,) and the remaining $1.40 is time value or extrinsic value (option price of $9.90 minus intrinsic value of $8.50 = time value of $1.40.) 

    So I only have to worry about $1.40 losing value over time.  But if all other factors (such as time before expiration) were to remain the same, and a few days later, the stock trades from $71.00 down $7.50 to around $63.50 (only one point away from the strike price,) we know that there will still be some value left in our call option (just as there is $4.60 of value in the call option in the table above that is only one point in-the-money.)  Thus, the call option will have lost less value than the stock did.

    The closer that the stock gets DOWN to the option’s strike price, the less the stock’s movement affects the option’s price (aka premium.)

    But if the stock were below the strike price, and moving higher, the delta would be increasing as the stock increased in price, so the stock’s movement would have an increasing effect on the price of the option.

  3. You want to have a decent amount of time left before expiration for the same basic reason.  Delta increases on ALL options the closer you get to expiration day.  That may sound complicated, but it’s very simple to understand. 

    Time value can be a bad thing, but it can also act as a shock absorber (a good thing if your stock trades in the wrong direction) and can work in your favor. 

    As you are in the last 90 days before expiration, your option will start to lose the time value at a much faster pace, so you start to lose the benefit of your shock absorber.  That is why you should be sure to have a decent amount of time before expiration.

    I personally like to decide what my time frame for the stock’s move will be, and then add three months to my option’s lifetime.  If I think the stock will do what I want it to in three months, I buy an option expiring in six months.  (This only refers to the straight buying of calls or puts.)

    If there is less than one day left before the option expires, then you can assume that there will be hardly any time value left in the option, right? 

    So let’s say we were looking at Exxon Mobil a few hours before the market closed on expiration day (no time left) and Exxon Mobile were trading at $63.00. 

    Since there is almost no time value figured into the call options price, you can assume that the Exxon Mobil 62.5 call option is trading at about 50 or 60 cents.  If Exxon traded up one point from $63 to $64, the option might trade up one point as well, from 50 cents to $1.50 or $1.60. 

    If Exxon Mobil traded up two points from $63 to $65, then the option with a few hours left before expiration might trade from 50 cents to $2.50 or so.

    Thus, the option that was nearly at-the-money, in this case, had a delta of 1.00 even though an at-the-money call option would have had a delta of 0.52 if the option had several months left before expiration!

    That is why having a nice time cushion on your side works to your benefit when the stock moves in the wrong direction.

    I told you that this would be Part 2 of a 3-part series.  I would be doing you a disservice if I only gave you half of the story. 

    Next week, I’m going to review what we discussed in Parts 1 & 2 VERY briefly, and then I will talk about this:

    There are several different variables that cause changes in an options price including: Stock’s Price, Time Decay, Implied Volatility, Delta and Interest rates.  You must understand that these other factors exist. 

    You probably understand time decay.  You hopefully are getting a nice grasp of delta.  You are well on your way to being light-years ahead of an options novice.  That means that you can make money most of the time instead of being part of the myth that “options lose money most of the time.”

    Here’s one fun activity in the meantime.  The next time your broker suggests that you trade options on something, test him.  Ask him to explain delta to you.  If he doesn’t seem to understand, then explain it to him.  Explaining it to someone who doesn’t understand is always a good exercise for me, and it will be a good exercise for you.

    I enjoy your comments and questions, so feel free to click the link below.

    Until next week.

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