What is Delta? This Answer Changed My Trading Life Forever (Part 3)
Tuesday, July 28, 2009 | Chris RoweRating:
For those of you who don’t know (shame on you), for the last two weeks (Tuesdays) we have been talking about understanding "delta," specifically the benefits of trading in-the-money (high-delta) options and how time impacts option values.Friends, we're just starting to scratch the surface of how trading high-delta options can enhance your profitability.
Learn it Once; Profit Many Times Over
Understanding delta could mean the difference between trading the right option contract that gives you low risk and high reward, or trading the wrong option contract that exposes you to unnecessary risk.
I'm actually updating a three-part series that I wrote in 2007, but even if you already read the series in the past, reading it again will almost certainly sharpen your knowledge on the subject and change your financial life.
Spending a few minutes here will save or make you several thousand dollars (or more). If you missed part 1 or part 2, you can find them by clicking on the following links: Part 1, Part 2.
I originally intended for this to be a three-part series, but there's so much information I want to share with you -- about how to make even more than you thought you could with options, while still taking a fraction of the risk -- that I'm going to add one more lesson after today on the power of delta.
So, be sure to tune in next week to Part 4 because I guarantee it will change your investing/trading life!
Let's Get Down to the Nitty Gritty
Just to refresh, delta is the ratio comparing the change in the price of the underlying asset (such as a stock or Exchange-Traded Fund) to the corresponding change in the price of an option contract.
We have been talking about it, not so much as a tool or a calculation, but more as a concept. The goal is for you to have a clear understanding of the reasons option prices change the way that they do.
Once you "get" that, you'll understand how and why trading options actually holds less risk than trading stock.
I'll keep talking about it conceptually, because it is most important to understand the concept. And, if you sit here and try to figure out how to actually calculate delta on your own or what the calculation is, you would really be missing the forest for the trees.
How options react when they are a certain distance away from their strike (or, exercise) price is what is important here.
By fully grasping the concept of delta, we understand why it pays to buy in-the-money options (giving you a higher delta) as opposed to trading riskier, lower-priced, out-of-the-money options.
A Savvy Way to Trade Cisco
For instance, check out Cisco Systems (CSCO) call options below. (Note: This is not a recommendation but instead an example.)
The CSCO Jan 20 Call options (green) are $6.28 "in-the-money." Said differently, they have $6.28 of intrinsic value. (CSCO trading at $26.28 - $20 strike price = $6.28 intrinsic value.)
These Jan 20 Calls are trading at $6.97 in this example, so the cost of the option only includes 69 cents of extrinsic value. (Option price or "premium" - intrinsic value = extrinsic value.) Thus, $6.97 - $6.28 = $0.69 extrinsic value.
Now we know (assuming that Cisco's stock price remained the same) that, out of the option's price of $6.97, only $0.69 (extrinsic value) is exposed to time decay, and the remaining $6.28 (intrinsic value) will only change based on the movement in the stock's price, and not due to time decay.
Now look at the Jan 27.50 Calls (red), which are trading at $2.10. Because the stock is NOT trading above this $27.50 strike price, we know that these call options are not in-the-money, but they are instead out-of-the-money (by $1.22).
We know that they therefore have zero intrinsic value and that 100% of the price of the option ($2.10) is extrinsic value. So, 100% of this call option is at the mercy of time decay, which means the entire investment of $210 per call option contract ($2.10 per share x 100 shares in a contract = $210) will deteriorate as time passes.
Let's study what would happen to each of the call options below when Cisco Systems gains or loses 10 points, and then what would happen if the stock drops 5 points.
The effect of a change in CSCO's price:
| Call Option | CSCO at current price $26.28 | CSCO up 10 at $36.28 | CSCO down 10 at $16.28 |
| Jan 17.5 | $9.17 | $18.93 ( $9.76) | $1.54 (-$7.63) |
| Jan 20 | $6.97 | $16.47 ( $9.50) | $0.72 (-$6.25) |
| Jan 22.5 | $4.99 | $14.04 ( $9.05) | $0.27 (-$4.72) |
| Jan 25 | $3.47 | $11.73 ( $8.26) | $0.12 (-$3.35) |
| Jan 27.5 | $2.10 | $9.44 ( $7.34) | $0.03 (-$2.07) |
| Jan 30 | $1.34 | $7.47 ( $6.13) | $0.01 (-$1.33) |
| Call Option | CSCO at current price $26.28 | CSCO up 5 at $31.28 | CSCO down 5 at $21.28 |
| Jan 17.5 | $9.17 | $13.98 ( $4.81) | $4.79 (-$4.38) |
| Jan 20 | $6.97 | $11.59 ( $4.62) | $3.09 (-$3.88) |
| Jan 22.5 | $4.99 | $9.28 ( $4.29) | $1.80 (-$3.19) |
| Jan 25 | $3.47 | $7.22 ( $3.75) | $1.05 (-$2.22) |
| Jan 27.5 | $2.10 | $5.24 ( $3.14) | $0.45 (-$1.65) |
| Jan 30 | $1.34 | $3.80 ( $2.46) | $0.25 (-$1.09) |
(The prices above assume that all other variables do not change.)
We said last week that there are many variables that can cause a change in the price of the option. The three major variables that impact the price of the option are:
1. A change in price of the underlying security (like the stock or ETF), which can cause the option to gain or lose value.
2. A change in "implied volatility" (expected future volatility), which can cause the option to gain or lose value.
3. "Time decay," which is when the option loses value at an accelerated rate as expiration day gets closer.
2. A change in "implied volatility" (expected future volatility), which can cause the option to gain or lose value.
3. "Time decay," which is when the option loses value at an accelerated rate as expiration day gets closer.
For today's discussion, we don't want to worry much about No. 2 and No. 3. We want to try to isolate No. 1 to a large degree.
It's important to remember that we trade high delta (deep in-the-money options) in order to replace stock trading. We don't want to worry much about the change in implied volatility, or time passing. We want our option to be affected by a movement in the price of the underlying security.
The call options that are deeper in-the-money (and have the higher deltas) gain the most (point-wise) when the stock moves higher.
With a movement in the underlying security within 24 hours, you can see that all of the call options above gain more in value when the stock moves up, than they lose when the stock moves down.
Cheaper Doesn't Mean Better
It may seem, at first glance, that the best options to trade are the cheaper ones because they "risk" less, point-wise, and they gain more percentage-wise. You can say the same thing about a lottery ticket.
But the laws of probability work against you, and that's not how we like to treat our hard-earned money. The objective here is to create an even better risk/reward ratio than a stock or ETF position gives you.
By now, you probably understand why, the lower the delta is, the more-aggressive the option is at that point. If your goal was not to replace the stock's performance with an option, but instead to speculate on an option, then you would be focused on the actual percentage gain or loss on the option itself.
The call option with the higher strike price is poised to give us the highest percentage gain possible. At the same time, the likelihood of making money is smaller and, if the stock doesn't do what you want, you are likely to lose much more -- if not all -- of the amount committed to the trade.
So, we know that if our crystal ball was working well and we knew for a fact that the stock would move up 5 points on the same or next day, then the out-of-the-money call is the best bet (with the highest-percentage return).
But guess what ... we don't always know exactly what will happen the same or next day, do we? In fact, we never know for sure what will happen.
Some people even think of the delta as being the probability of the option trading in-the-money at expiration. (A delta of 20 indicates that there is a 20% chance of the option being in-the-money at expiration; a 50-delta option has a 50% chance of expiring in-the-money, and so on.)
It's smarter to buy the in-the-money option (which has the higher delta) even if your focus is solely to speculate on the option itself. But today we're talking about the option's price in relation to the underlying stock.
The two considerations here are the effect of time decay, and the effect of price fluctuation. The chart above assumes that the stock moved today, so time decay is eliminated from the example.
But you can see that, even though time didn't pass, the extrinsic value did decrease when the stock moved higher. This is the other way that the extrinsic value disappears. (And this is one reason why I don't like to refer to the extrinsic value as "time value" as many people do.)
Our Goal
But you can see that, even though time didn't pass, the extrinsic value did decrease when the stock moved higher. This is the other way that the extrinsic value disappears. (And this is one reason why I don't like to refer to the extrinsic value as "time value" as many people do.)
Our Goal
What we want to do when buying calls in place of the stock is we want to buy the call option that comes as close as possible to mimicking the gains in Cisco's stock. (If the option traded in parity with the stock -- for example: CSCO trades up 5 points, causing the option to also trade up 5 -- then the option would have the highest possible delta of 1.00. The deeper in-the-money the option is, the higher the delta is; the closer the option's price comes to mimicking the stock's price.)
You can see above that the call options with the lower strike price (which have the higher delta) gain more, point-wise, when Cisco moves higher, than the call options with the higher strike price (which have the low delta). You can also see that the call options with the lower strike price (which have the higher delta) lose less, point-wise, than Cisco's stock.
While the examples above assume that the move happened today, this would remain the case for the next several months.
Time Flies ... and Can Take Your Premium Away With it
If you want to benefit from this feature, you should trade the options that have at least three months left before the expiration day. If you hold the Cisco options for a few months, and you realize that expiration day will be in three months, then what you should do is sell the calls that you own, and buy the calls with an expiration day that's further out. This way, you can keep your call options gaining more and losing less.
Here, it's easy to see one of the benefits of owning call options that are in-the-money.
But what about the time factor? Well we already know that anything that's out-of-the-money would be worthless at expiration.
If Cisco traded flat until expiration, the Jan 30 Call and the Jan 27.50 Call, which are out-of-the-money, would lose all value. The Jan 25 Call would be at $1.68 (the in-the-money amount -- aka, intrinsic value).
However, our Jan 20 Call, which was trading at $6.97 and only had 92 cents of extrinsic value, would be at $6.28. (Again, the intrinsic value of $6.28 is not affected by time decay.) So, a very small percentage of the investment, relative to the other two (Jan 30 and Jan 25), was affected by time decay.
We've covered the impact on the Cisco options if the stock moved today. We've covered what would happen if the stock didn't move at all until expiration. But what would happen to the options in six months from now if the stock moved 5 points higher, 5 points lower, or traded at the same price that it started at ($26.28)?
Here's where the options would trade:
You can see above that the call options with the lower strike price (which have the higher delta) gain more, point-wise, when Cisco moves higher, than the call options with the higher strike price (which have the low delta). You can also see that the call options with the lower strike price (which have the higher delta) lose less, point-wise, than Cisco's stock.
While the examples above assume that the move happened today, this would remain the case for the next several months.
Time Flies ... and Can Take Your Premium Away With it
If you want to benefit from this feature, you should trade the options that have at least three months left before the expiration day. If you hold the Cisco options for a few months, and you realize that expiration day will be in three months, then what you should do is sell the calls that you own, and buy the calls with an expiration day that's further out. This way, you can keep your call options gaining more and losing less.
Here, it's easy to see one of the benefits of owning call options that are in-the-money.
But what about the time factor? Well we already know that anything that's out-of-the-money would be worthless at expiration.
If Cisco traded flat until expiration, the Jan 30 Call and the Jan 27.50 Call, which are out-of-the-money, would lose all value. The Jan 25 Call would be at $1.68 (the in-the-money amount -- aka, intrinsic value).
However, our Jan 20 Call, which was trading at $6.97 and only had 92 cents of extrinsic value, would be at $6.28. (Again, the intrinsic value of $6.28 is not affected by time decay.) So, a very small percentage of the investment, relative to the other two (Jan 30 and Jan 25), was affected by time decay.
We've covered the impact on the Cisco options if the stock moved today. We've covered what would happen if the stock didn't move at all until expiration. But what would happen to the options in six months from now if the stock moved 5 points higher, 5 points lower, or traded at the same price that it started at ($26.28)?
Here's where the options would trade:
|
Call Option
|
Original Price
|
CSCO remains at $26.28
|
CSCO up 5 at $31.28
|
CSCO down 5 at $21.28
|
|
Jan 17.5
|
$9.17
|
$8.80 (-$0.37)
|
$13.98 ($4.81)
|
$3.97 (-$5.20)
|
|
Jan 20
|
$6.97
|
$6.33 (-$0.64)
|
$11.30 ($4.33)
|
$1.93 (-$5.04)
|
|
Jan 22.5
|
$4.99
|
$3.98 (-$1.01)
|
$8.80 ($3.81)
|
$0.64 (-$4.35)
|
|
Jan 25
|
$3.47
|
$2.00 (-$1.47)
|
$7.22 ($3.75)
|
$1.05 (-$2.22)
|
|
Jan 27.5
|
$2.10
|
$0.78 (-$1.32)
|
$4.04 ($1.94)
|
$0.02 (-$1.05)
|
|
Jan 30
|
$1.34
|
$0.23 (-$1.11)
|
$2.21 ($0.87)
|
$0.00 (-$1.34)
|
The options above illustrate the impact of Cisco's stock price on the options, assuming that there are only 60 calendar days left before expiration.
See the difference?
This is why I prefer to exit the long option position at least three months before the expiration day. If you want to benefit from the reduced risk of the stock trading lower, you might want to play it this way, too.
Don't Let Your Profits Decay With Time
Let's take a look at the chart below so that you understand why I like to be out of a position before the last three months to expiration.
This was an actual trade I made early on in my career, where I bought a call option that gave me the right to buy IBM at $100 per share. I think that the option had about three months of time left before expiration.
When the stock was at $101.50, the IBM $100 call was $1.50 in-the-money. The call option was trading at $4. So, out of the $4 premium that the call option was trading at, the remaining $2.50 was extrinsic value.
If you study the time decay chart below, you will see the way that the decay of extrinsic/time value (aka, "time decay") accelerates. All options will react differently, since all of the variables change depending on the specific option's situation. But you get a basic understanding with this chart.
See the difference?
This is why I prefer to exit the long option position at least three months before the expiration day. If you want to benefit from the reduced risk of the stock trading lower, you might want to play it this way, too.
Don't Let Your Profits Decay With Time
Let's take a look at the chart below so that you understand why I like to be out of a position before the last three months to expiration.
This was an actual trade I made early on in my career, where I bought a call option that gave me the right to buy IBM at $100 per share. I think that the option had about three months of time left before expiration.
When the stock was at $101.50, the IBM $100 call was $1.50 in-the-money. The call option was trading at $4. So, out of the $4 premium that the call option was trading at, the remaining $2.50 was extrinsic value.
If you study the time decay chart below, you will see the way that the decay of extrinsic/time value (aka, "time decay") accelerates. All options will react differently, since all of the variables change depending on the specific option's situation. But you get a basic understanding with this chart.
Notice that the time value portion of the option only loses 10% (from 100% to 90%) of value in the period with nine to six months left, the period with six to three months left loses 30 more percentage points (from 90% down to 60%), and the remaining 60% of the extrinsic-value portion of the price gets clobbered in the last three months.
Again, remember that the red part that loses value is the extrinsic value, and you can see that the green part is the intrinsic and is not affected by time decay.
Do yourself a favor and stare at this for a LONG time. This alone could actually make you a better options trader.
I hope that I have kept someone from making a terrible mistake. I hope that I have caused someone to make smarter options decisions. I hope that I have demystified the price action of options with respect to time decay and delta. And I hope that you understand why options can be used to REDUCE risk and increase leverage at the same time.
Please note that I am still working on the tool I told you about last week that will make it easy to pick the right option to trade in place of the stock. I apologize for the wait, but I am working out a couple of kinks.
Also next week, tune in for Part 4 of "What is Delta? This Answer Changed My Trading Life Forever."
(Please let us know what you think about Chris Rowe's article.)
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“Profit from the Trend”
Chris Rowe
Chief Investment Officer
The Trend Rider
