Delta: An Option Trader’s Best Friend (Part 1)
12/31/2009 12:01 am EST
I am not exaggerating when I say that gaining an understanding of delta changed my trading life forever. And I promise that this multi-part series will be one of the most important and influential investing lessons you've ever had.
Even if you don't trade options, you should still read this, because it can significantly reduce your risk in this market. You can learn how to replace your overpriced stock with call options—but you must know which options 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:
1) If you sell your stock and buy call options to replace it, then buy "in-the-money" call options
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 January 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 article 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 options).
What Is Delta?
The "delta" of an option measures how much the option changes in price when the underlying security moves one point.
For example, let's say that XYZ stock is trading at $65 per share, and the XOM January 65 call is selling for $5. (NOTE: Because XYZ's stock price is the same as this option's strike price, this option is trading at the money.)
When XYZ rises one point (from $65 to $66), the January 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. A call with a delta of 0.70 implies virtually the same thing as a put with a delta of -0.70.
You will notice that when a call option is far out of the money (for example, the XOM January 95 call is 30 points out of the money), it will move only slightly (or not move at all) when the stock rises by one point.
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 four 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 four-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 four-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 that the option ends up profitable.
Out-of-the-money options have the lowest deltas, while in-the-money options have the highest deltas. 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 XYZ January 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.|pagebreak|
Two Important Notes:
1) An Option's Delta Changes as the Price of the Stock Changes
This is because the deeper in the money that an option becomes (due to the price movement of the underlying stock), the higher the delta becomes. In other words, in the ExxonMobil example, when XOM moves up five points from $65 to $70, the delta of the January 65 call would move up from 0.50 to 0.65.
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 that if a call option has a delta of 0.50, that the call option would only move up by five points if the stock moves up by ten. 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 ten points (from $65 to $75), the January 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) An Option's Price (and the Option's Delta) Can Be Affected by Other Factors
In the first part of this series, we are only discussing delta. But 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 Versus Gambling with Options
The reason that so many people shy away from options trading and think that options 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 that trades at $20. They make the mistake of ignoring the probability of the stock trading higher. This is a common mistake made by inexperienced investors, and it is one of the absolute worst ways to approach investing.
The two reasons investors mistakenly think cheap options are better are:
1) If the investor is successful, the win will be greater, percentage wise, and…
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."
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 the odds favor a loss, why invest even $1?
We must look at our investment portfolio as a business, and not a lottery ticket.|pagebreak|
Is Purchasing Out-of-the-Money Options Ever a Good Trade?
More specifically, not if you're purchasing those options by themselves. However, if you buy them as a hedge, or as part of a multi-leg option position, that's a different story.
But we are talking about stock replacement here, 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 we'll stick with call options in our examples.)
Below, you can see eight call options listed for Exxon Mobil (XOM) back in July of this year. 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 least likely to advance is the January 85 call (at the bottom), and the option that is the most likely to advance is the January 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 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 were 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.|pagebreak|
Trading with a Low Delta
Suppose XOM is trading at $80, and a trader is looking to buy call options because he is looking for a move of one point from $80 to $81.
If the trader were to buy the October 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, we assume that the stock moved the very same day) you could assume that the October 85 call options would move approximately 37 cents higher.
The Argument for Buying Low-Delta Options
If you bought the option at $2.35 and sold it 37 cents higher (within a day or two) at $2.72, then you would realize a fast 15.74% return on our money. Not bad.
If you have $7,050, you could buy 30 call options (representing 3,000 shares) and you would make $1,110 within a day or two.
If you got lucky, and you underestimated XOM's upside move, and it happened to trade to $95 (instead of $81), then you would make a killing (more than $30,000 on your $7,050 investment)!
However, before you start mentally spending those profits…stop!
I can see the greed seeping out of your ears right now! A wise man once told me that the traders who make huge profits like that are the same ones who take a lot of big 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 Argument Against Buying Low-Delta Options
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, while the second is what many people overlook.
1) The Lower the Delta, the More Extrinsic Value Your Option Contract Consists of
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) January 20 call with the stock trading at $22.50, then my call option is $2.50 in the money.
If that SGP January 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. (Keep in mind that these are not recommendations. They are examples to illustrate the power of delta.)|pagebreak|
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.
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 January 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 January 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 premium).
2) Starting with a High Delta Reduces Your Loss When the Stock Moves in the Wrong Direction
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 January 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 January 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 farther out than 90 days. (Remember, 90 days before expiration is when the extrinsic value decay tends to speed up.)
NOTE: When you buy an option strictly for the upside (and you aren't using it for hedging purposes), you should always give yourself extra time for it to work. Try to buy it with an expiration month that is at least 90 days after the time that you wish to sell it.
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 the 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 SGP traded from $22.50 down three points to $19.50, the January 20 call is likely to lose only about $2.30 in value.
So, why even bother trading stock? What if the stock drops by ten 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. Part two tomorrow is where you'll learn how to turn your deltas into dollars!
By Chris Rowe, chief investment officer, Tycoon Publishing's The Trend Rider.