By: Chris Rowe — July 13, 2009
What is Delta? This Answer Changed My Trading Life Forever (Part 1)
Happy Tuesday, Tycoons!
Given the current market environment, where an overbought market has begun to sell off and people are wondering how low the drop will be, I thought that it would be a good idea for me to revisit this three-part series that I wrote last year because of its high level of importance. I've improved it with a few changes geared toward helping you to improve your trading game even more.
Even if you remember reading it, it's still a good idea to review it. This will be one of the most important and influential lessons you have ever learned about investing.
Even if you don't trade options, you should read it. Why? Because they can significantly reduce your risk in this market. You can replace your overpriced stock with some call options ... but you MUST know which option to buy, or else you might actually increase your risk instead.
Learning about delta and using it to make better trades is not really complex, so don't be intimidated. Just remember the two most important things:
2) Only buy one call option for every 100 shares of stock that you own (or, would want to own). In other words, if you have 100 shares of Capital One Financial (COF), and want to close the position at $21.60, you will have $2,160. To establish an option position, you should buy only one call option contract (which represents 100 shares). If you buy the COF Jan 15 Call and pay $8 per contract (an $800 investment), then you should put the remaining $1,360 in a safe, interest-bearing security, such as a money-market fund or Treasuries.
This three-part series will help you understand why it's important to buy in-the-money call options in place of stock (as opposed to at-the-money or out-of-the-money).
And Now, to Change the Lives (and Returns) of People Smart Enough to Listen...
Most stockbrokers and money managers have no real concept of what I’m about to talk about. Don't worry, that doesn't mean it's complicated at all.
And if you are a professional money manager of some sort, then pay close attention. If you understand options, you can use the following knowledge to help your customers, as well as your business, enormously!
Today, You Will Learn About 'Delta'
The "delta" of an option measures how much the option changes in price when the underlying security moves one point.
Let’s say that ExxonMobil (XOM) is trading at $65 per share, and the XOM Jan 65 Call is selling for $5. (NOTE: Because XOM’s stock price is the same as this option’s strike price, this option is trading "at-the-money.")
When XOM rises one point (from $65 to $66), the Jan 65 Call should then sell for $5.50. Thus, the option only increases by 50 cents when the stock rises by one full point. This at-the-money option is said to have a delta of 0.50.
Decoding the Delta
The delta of an option is a number that ranges from 0.00 to 1.00, and the delta of a put option is a number that ranges from -1.00 to 0.00.
The delta of this FAR out-of-the-money call is only 0.04. So theoretically, if XOM moved up by one point, the price of the $95 calls should advance by 4 cents.
Now, that might seem like a lot in terms of the percentage gain since the theoretical value of this far out of the money option is about 27 cents. (A 4 cent gain would be a 15% gain on a 27 cent call option). But you have to consider the fact that the spread between the bid and ask price can be much larger than the 4 cent gain in the option (so you can still end up with a losing position).
The rule of thumb here is the higher the delta is, the more likely it is the option ends up profitable. And out-of-the-money options have the lowest delta, and in-the-money options have the highest delta. So you'd want to avoid the out-of-the-money option that has the delta of 0.04 like the plague.
On the other hand, if the stock is trading far above the call option’s strike price -- or, said differently, the option is deep "IN-the-money" (i.e., the XOM Jan 45 Call, which is 20 points in-the-money with the stock trading at $65), then the call option would likely have a delta of 0.96.
Thus, when the stock moves up one full point, the option will likely move up 96 cents. (Almost point-for-point, aka trading at "parity" with the stock.)
If a call option moved up one full point due to the underlying stock moving up one full point, then the option has a delta of 1.00, and so on.
A put option would work the same way whereas, if XOM moved down one point, a PUT option that has a delta of -0.70 would move up by 70 cents.
2 Important Notes
Theoretically, at that point (with XOM at $70), if the stock moved up one point (from $70 to $71) then the call (which now has a delta of 0.65) would increase by 65 cents.
So don't mistakenly think, if a call option has a delta of 0.50, that the call option would only move up by 5 points if the stock moves up by 10. That is incorrect because, again, the call option's delta increases as the option moves further above its strike price.
The more the stock advances, the more sensitive the option's price will be to each one-point movement of the stock. In fact, if ExxonMobil traded up 10 points (from $65 to $75), the Jan 65 Call -- which currently has a delta of 50 -- would actually advance by approximately $7 (from $5 to $12).
By the time the stock is trading at $75, the delta would move up to about 0.78.
2) Today we are only discussing delta. But an option’s price (and the option's delta) can be affected by other factors. The two major factors that impact an option's price and delta are "time decay" and a change in "volatility" of the underlying stock, Exchange-Traded Fund, index, etc.
Replacing Stock with Options vs. Gambling with Options
The reason that so many people shy away from options trading and think that they are so risky is because the option novice tends to be attracted to the lower-priced options, which are the options that are the most difficult to profit from.
This is similar to the situation when people say that they would rather buy a stock that trades at $2 instead of a stock which trades at $20. They make the mistake of ignoring the probability of the stock trading higher. That is one of the absolute WORST ways to approach investing in the market, and it happens to be a common mistake made by inexperienced investors.
The two reasons investors mistakenly think cheap options are better are:
2) If the investor is wrong, then he or she will have only lost the small amount invested.
But clearly, you can't argue both. You can't say the percentage gain is larger and then make the argument for the loss that the absolute number is "all you would lose."
And consider the first reason. Sure, the percentage gain might be higher if everything works out. But when the odds of success are low, you wouldn't feel comfortable putting any real money behind the investment.
Personally, I don't care if it's $5 or $500,000. No matter how much money you are putting at risk, the odds of success should be good. If odds favor a loss, why invest $1?
We must look at our investment portfolio as a business, and not a lottery ticket.
Is Purchasing Out-of-the-Money Options Ever a Good Trade?
No. More specifically, not if you're purchasing those options by themselves. However, if you buy them as a hedge, or as part of an multi-leg option position, that's a different story.
But today, we are talking about stock replacement, which just involves buying an option instead of a stock. I'm going to show you how to take less risk than the traditional stockholder.
First, you should understand that an out-of-the-money call option is an option that has a higher strike price than the current price of the stock. (With put options, it's the opposite. With puts, the out-of-the-money options are those with a strike price that is lower than the stock price. But let's stick with call options in our examples.)
Below you can see eight call options listed. The strike prices are circled in red. The stock is trading at $65.70. The call options that are highlighted in yellow are the out-of-the-money options. You can also see these are the cheaper options, and they get cheaper with higher strike prices.
The option that is the absolute least likely to advance is the Jan 85 Call (at the bottom), and the option that is the absolute most likely to advance is the Jan 50 Call (which is 15.7 points in-the-money).
Many option traders lose money trading out-of-the-money options because they are overly confident in their prediction.
For example: They may think a stock will trade from $65 to $80 in a given period of time. But most of the time, markets and stocks trade plus one or minus one standard deviation from the mean.
That is why "time decay" tends to be a factor that new, out-of-the-money option, traders learn about very quickly (and painfully).
An out-of-the-money option’s delta will trend toward zero as time passes. And remember, the lower the delta is, the less the price of the option will be impacted by the movement in the stock.
Therefore, the underlying stock can trade much higher over time, but the call option with a very low delta could still trade lower, even to zero, even though the stock traded higher.
I'm sure many of the people reading this have bought an out-of-the-money call option because they thought the stock was going to advance, and they were right because the stock advanced, but disappointed because the call options traded lower anyway. That's because they bought the wrong call option. At the same time, other call options traded higher with the stock.
Trading with (what I consider to be) a Low Delta
Suppose XOM were trading at $80, and a trader was looking to buy call options because he was looking for a move of one point from $80 to $81.
If the trader were to buy the Oct 85 Call (which is five points out-of-the-money), the trader would pay $2.35 for the call option.
This call option has a delta of 0.37. That means that if XOM traded from $80 to 81, (all other factors being equal -- such as ZERO time decay -- so we assume that the stock moved the very same day), you could assume that the Oct 85 Call options would move approximately 37 cents higher.
The Low-Delta 'POSITIVE' Argument
If we bought the option at $2.35 and sold it 37 cents higher (within a day or two) at $2.72, then we would realize a fast 15.74% return on our money. Not bad.
If I have $7,050, I could buy 30 call options (representing 3,000 shares), and I would make $1,110 within a day or two.
If I got lucky, and I underestimated XOM’s upside move, and it happened to trade to $95 (instead of $81), then I would make a killing (over $30,000 on my $7,050).
However, before you start mentally spending those profits ... STOP IT!
I can see the greed seeping out of your ears right now. A wise man once told me that the traders who make the HUGE profits like that are the same ones that take LOTS of huge losses.
Remember, the low-delta options are the out-of-the-money options, and it's very likely that they don't end up profitable.
The Low-Delta 'NEGATIVE' Argument
I usually don’t like to buy an option with a low delta unless I am covering (hedging) myself against a significant stock movement/loss. (Such is the case when using a protective put.)
There are two main reasons why, and both reasons spell a higher risk with lower delta. The first is one that most people understand; the second is what many people overlook.
Extrinsic value (aka, time value) is what is left over after calculating intrinsic value. Extrinsic value is affected by time decay.
Intrinsic value is the amount by which your option is in-the-money. Intrinsic value is NOT affected by time decay.
If I own a Schering-Plough (SGP) Jan 20 Call, with the stock trading at $22.50, then my call option is $2.50 in-the-money.
If that SGP Jan 20 Call is trading at $3, then $2.50 of that $3 is intrinsic value, and the remaining 50 cents is extrinsic value and is exposed to time decay.
(Remember, these are not recommendations but, rather, examples to illustrate the power of delta.)
Remember: The extrinsic value (or time value) portion of an option is at the mercy of the clock. Time decay has zero effect on the intrinsic value portion of my options premium. That's why we like to trade in-the-money options that have minimal extrinsic value (time value).
Notice in the table above that the percentage of the value of the option contract, that is extrinsic value, increases as the delta decreases. So, the lower the delta, the more extrinsic value exists. And that extrinsic value is at the mercy of time decay.
For example: The extrinsic value of the Jan 17.50 Call (with the highest delta of 0.97) only accounts for 5.7% of the entire value of the option. This means that only 5.7% of the value can be lost due to time passing. Any other loss in the option would have to do with the actual stock moving lower.
Twenty percent of the Jan 20 Call is extrinsic value and is therefore at the mercy of time decay. The other two options have 100% extrinsic value.
Now, just about every options trader understands that time decay occurs as time passes, and most are familiar with what a time decay curve looks like.
The deterioration of the extrinsic value portion of the call option’s value accelerates, especially in the last 90 days before expiration.
By purchasing an option that has a high delta, I can significantly reduce the effect that time decay has on my option's value (or the option's premium).
This is what an alarming number of option traders either don’t understand, or only have a slight understanding of.
Remember how I said that the delta of a stock option changes as the stock fluctuates? For example, in the table above, you see that the delta of the Jan 20 Call (which is 2.5 points in-the-money) is 0.84. It has such a high delta because it is 2.5 points in-the-money.
But if SGP traded down to $21, the Jan 20 Call would only be one point in-the-money. Thus, the delta would change from 0.84 to 0.69.
This is a good thing if you are the owner of that call option. It means that as SGP stock trades lower, the call option actually loses less in value (dollar-wise) than the stock!
In other words, you stand to lose a lot less by owning the call option. This is especially true when you are talking about an option that has an expiration day further out than 90 days. (Remember, 90 days before expiration is when the extrinsic value decay tends to speed up.)
Think about that for a second.
This is the part that many newer option traders tend to overlook, and it's one of the most important considerations when using beginner, intermediate or advanced option strategies.
Buy More Delta, Lose Less if Trade Goes South
When you buy options with a high delta (which are deep in-the-money) and the stock trades lower, your option loses less value than the stock does!
So, you put up less capital (and therefore ultimately risk less capital), and the call option holder will actually lose less value when the stock trades down a few points. If Schering-Plough traded from $22.50 down three points to $19.50, the Jan 20 Call is likely to lose only about $2.30 in value.
So, why even bother trading stock? What if the stock drops by 10 points? You'd only lose a maximum of $3 that you committed to the option as opposed to the $10 that the stockholders lost!
There's more to this, and it gets even better.
Tune in next week, and I will give you PART TWO of "What is Delta? The Answer Changed My Trading Life Forever," where you are sure to add invaluable weapons to your arsenal that even your broker can't comprehend.
Don't forget to click on the link below to rate this article and to leave comments!
Until next week,