Delta: An Option Trader’s Best Friend (Part 2)

01/01/2010 12:01 am EST

Focus: OPTIONS

In yesterday’s Part 1 of this article, I started to teach you about the importance of understanding delta when trading options.

One thing that I want to discuss in the second part of this series is the fact that there are so many options available to trade on each individual stock that expire in one particular month that it might be easy to misinterpret what I was saying last week about how to harness the power of delta to choose the best options to trade.

To review, 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.

For example, if XYZ trades at $50, the XYZ April 45 Calls will move up more (point-wise) than an XYZ April 50 Calls.
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.

Going, Staying In-the-Money

But this 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 stock price.

Why?

Because if you buy a call that is too far in-the-money, you cannot only make 98 cents on a one-point gain in a stock, but you can lose 98 cents on a one-point loss in the stock. And you want to enjoy the benefit on both sides of the trade.

For example, I had taken some bearish positions recently because just about every sign the market gave us said it was going to trade much lower. But even if there were a 90% chance of that happening, of course, there would still be a 10% chance of it not happening.

In other words, it was a good thing we owned the right options—that is, the options that would have gained a lot more if the market moved down as I thought, than they lost when the market went in the other direction (up).

The Way to Turn Your Deltas Into Dollars

Now the market has started to move up again and you're going to start to profit from bullish positions.

What you want to do is this: Instead of buying stocks or exchange traded funds (ETFs) outright, buy deep in-the-money call options on the strongest stocks or ETFs.

You want to position yourself so that if the stock moves up several points, 85%-90% of that gain will be reflected 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 reflected in your option.

How do we do this?

When I buy a call option 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 two to five series in-the-money. That is, from the current market price of the stock, I will examine the call options that are two to five strikes below the market price, and the puts that are anywhere from two to five strikes above the market price of the stock.

This rule of thumb varies, depending on how high or 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 to 0.80.

For instance: Let's say that I want to buy call options on Exxon Mobil (XOM) with the stock trading at $69. (Note: This is not an actual recommendation. It is used purely as an example).

Keep in mind, an option contract's price has two parts: Intrinsic value and extrinsic value (or time value).

The amount by which the option is in-the-money (ITM) is the intrinsic value, and the time value is the remainder.

How do you determine the ITM amount?

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Well, for example, when the stock is trading at $69, the XOM Jan 60 Call is $9 ITM. ($69 stock price - $60 strike price = $9 intrinsic value).

So with XOM trading at $69, if I decided to buy the call options that expire in January, the part of the option chain that I would focus on would look something like the first two columns:


Click to Enlarge

Since the stock is trading at $69, and the ITM call options are the ones that have a strike price lower than the stock price, the Jan 65 Calls would be one series in-the-money. The Jan 60 Calls are two series in-the-money, the Jan 55 Calls are three series in-the-money, and so on.

(Side note for later: The options that are deeper in-the-money have increasingly higher deltas. When the option is in-the-money (higher delta), it becomes more sensitive to the stock's movement).

So, as XOM advances, the call options will become more sensitive to the move (and the delta of any of the listed call options will increase). However, if the stock declines, the call options will become less sensitive (as the delta decreases).

That's why, although you want to buy ITM call options, you don't want to buy the call options that are too far ITM (where the delta is too high).

If the stock trades down, you want to retain some value in your option. You want the "shock absorber" (decreasing delta) that comes into play when the option moves lower (and closer to the strike price).

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

Buying Time...Literally

We've talked about stock prices and intrinsic value. But many factors impact an option's price, like time and volatility, which contribute to an option's extrinsic (time) value.

So, when you're buying options, in addition to looking for higher delta, you also want to look for those options that:

1. Have little extrinsic value (aka, time value).

2. Will still give you a decent return.

3. Have an expiration date that is at least three months later than the time you expect to exit the option contract (i.e., you don't want to own an option contract that expires within three months).

If you find yourself in an option that does expire in three months or less, you can always close that position and buy another option with a further-out expiration month and pay a little extra for more time.

Why do we care about the amount of time value in the price of the option?

The less time value that you have in your option; the less money is at risk of disappearing due to time decay as the option approaches expiration.

Why is it okay to have some time value in the price of the option?

To use an extreme example, you can essentially eliminate time value by buying a call option that is super deep in-the-money, like the XOM Jan 20 Calls (which would be 49 points ITM).

But you wouldn't want to do that because, if XOM moved five points higher, you would only make about five points on your $49—that's less than 10%!

While you could do that, it doesn't excite me to pay a lot for an option for such a small percentage return.

At the same time, because the stock's price is so far ITM, the delta will remain high (near 1.00) even if the stock trades lower instead of higher. And that means your option would decline by the same amount that the stock declines. So, if the stock drops five points, so would your option.

This is a key point that I am trying to make. I explained in Part I 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 ITM, the reduction of risk (when compared to stock) lessens.

NEXT: How Deep in the Money Is Too Deep?

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How Deep in the Money Is Too Deep?

If you were to buy the XOM Jan 20 Calls (49 points in-the-money) when the stock is trading at $69, and then the stock traded down 20 points, then the call option would also trade down almost 20 points.

The idea is to buy options that are ITM, but still relatively close to the strike price. Again, I like to buy two to five series ITM (in XOM's case, the Jan 60 Calls at $10.25 might be a comfortable distance from the stock price of $69).

Why are the Jan 60 Calls appealing? These calls are $9 ITM. This means that within the option's price of $10.25, $9 is intrinsic value (which is not affected by time decay), and the remaining $1.25 is time value or extrinsic value (option price of $10.25 - intrinsic value of $9 = time value of $1.25).

So, I only have to worry about $1.25 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 $69 down by $8 to around $61 (only one point away from the $60 strike price), the option would probably only trade down $5.25 to $5.

Thus, the call option will have lost less value than the stock did.

The closer that the stock trades down to the option's strike price, the less the stock's movement affects the option's price (aka, premium).

But if the stock moves higher, the delta would be increasing, so the stock's movement would have an increasing effect on the price of the option.

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. This 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.

What Happens at Expiration?

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. This is why you should be sure to have a decent amount of time before expiration.

That's why I said to decide what your time frame for the stock's move will be, and then add three months to the option's lifetime. If I think the stock will make the move I expect within three months, then 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 XOM a few hours before the market closed on expiration day (i.e., no time left) and the stock was trading at $63.

Since there is almost no time value figured into the call option's price, you can assume that the XOM Jan 62.50 Calls are trading at about 50 cents or 60 cents. If XOM 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 XOM 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 only slightly ITM, in this case, had a delta of 1.00.

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

By Chris Rowe

Chris Rowe is the Chief Investment Officer for Tycoon Publishing's The Trend Rider.

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