Several months ago I wrote an article concerning the Greeks, which measure an option’s exposure to risk. Those of us who study options are constantly reading and hearing that delta, one of the greeks, is one of the most powerful influences over option value. Because of this and your interest in the subject, as expressed in your emails, I thought it prudent we discuss this subject in greater detail.
Definition:
Delta measures the amount an option price will change as a result of a $1.00 price change of the underlying security (stock, ETF). Other major factors that impact option value include the price of the stock, implied volatility and time to expiration. Since call options rise and fall directly with the price of the stock, they are assigned deltas between 0 to 1.
Look at delta as a bet: What is the percentage chance that the option will end up in-the-money (lower than the market value of the stock) or be exercised by expiration Friday? The higher the delta value, the greater the chance of this happening. A delta of .9 or 90%, for example, means that the strike price will almost definitely end up I-T-M. In the scenario where we sold a $50 call and the stock is trading @ $70 with one week remaining, the delta will be at or near 1 and for every $1 change in the price of the stock, the option will also change by approximately $1. This is typical of deep I-T-M strikes.
For at-the-money strikes, deltas will be closer to .5 or 50%. In this scenario, for every $1 change in the price of the underlying, the option value will change by $.50, reflecting about a 50-50 chance that the strike will end up I-T-M.
For deep out-of-the-money strikes, deltas would be quite low, between .1 to .2 or 10% to 20%, for example. If we sold the $50 call and the stock was trading @ $30, the odds of that $50 ending up I-T-M is quite low. If the stock price moves up or down by $1, the option value will change by perhaps .10 because of the low delta.
The chart below summarizes the approximate deltas for the 1-month options we sell when writing covered calls:
Deltas for 1-Month options
RULE:
Delta values increase as the strike moves further I-T-M and decrease as the strike moves deeper O-T-M. This can be visualized in the graph below:
Delta vs. Strike Prices
-
I-T-M strikes- highest deltas
-
A-T-M strikes- deltas near 50% or .5
-
O-T-M strikes- low deltas
Strike selection based on delta:
-
I-T-M strikes- if bearish or conservative as option premiums will decline faster with decreasing share price making it easier to B-T-C.
-
A-T-M strikes- for maximum premium return.
-
O-T-M strikes- if bullish so option premium AND share appreciation can be realized.
Conclusion:
Understanding the relationship of delta to our option premiums will make us sharper investors as it will allow us to select the best strike price for a given situation.
Should we continue to write calls on declining stocks?:
The recent global market decline has spurred many emails similar to the one Dave sent:
One of the stocks I currently own is HEAT. I purchased this stock for $16.30 and currently the stock is at $11.07… This is a loss of 5.23… BUT, with the option profits I have made (.80c + 1.35) its only 3.13…
If I sell now, I incur a loss of around $3.00.
On the other hand, if I hold the stock and continue to sell options on it, perhaps I will lessen the loss and eventually arrive at a profitable position… What are your thoughts of doing this? In your experience, is this a wise thing to do?
I felt that I should address this briefly in this article and in greater detail in a well-prepared future commentary. So we have a declining stock and the question is: Do we roll down, take no action and hope the stock appreciates in value, look to hit a double, sell the stock and stay in cash, or convert dead money to cash profits (sell the stock and use the cash to open a new position)?
Here are two assumptions I make that factors into my decisions:
1- There is nobody out there who can accurately time the market and I mean nobody. We can, however, make some common sense conclusions that will dramatically throw the odds in our favor.
2- Freezing up and doing nothing is the worst decision an investor can make…it’s really not even a decision, it’s a non-decision.
So now we’re down to 4 possibilities:
- Rolling down
- Looking to hit a double
- Selling the stock and opening a new position
- Selling the stock and staying in cash
As we are standing at the crossroads of these 4 paths, there is one question I ask myself to help guide me: Why is the stock declining? So we must check the news. I am not talking about the normal whipsaw up-and-down movement of an equity over time. I’m referencing the precipitous drop in price that Dave was alluding to with HEAT. (We don’t have to check the news on every stock that goes up or down $0.50). For example, a few weeks ago many of us suffered through a severe loss in MED, the stock of the decade! We checked the news and found that there were allegations of corporate fraud. I sold half my position that day and the rest a few days later. Now, if MED had dropped a few dollars in price with no news but was trading above support (moving average) after a run-up, hitting a double would have been my goal. In this last scenario, if the price did not rise within a reasonable time frame, I may have switched my goal to rolling down. Finally, if in that same scenario, had the stock continued to decline, I would look to unwind my position and sell the stock. If, in normal market conditions, I would then put that cash to work and open a new position as I almost always want to keep my money working for me. So let me summarize this way: With extreme negative news, I unwind my position and move on to a new equity. Otherwise I reference the chart and look for moving average support. If support is broken on high volume with MACD and stochastics negative, I will unwind. Otherwise, hit a double and roll down in that order.
Now, all that being said, none of it applies to Dave’s current situation (I’m sorry to say). That’s because we are in a near market correction of late and almost ALL stocks are being dragged down. Lately, it’s been shades of 2008 and 2001. The charts of the S&P 500 and the VIX are telling us that the general market tone is negative and that is like swimming upstream with a shark in pursuit. In these cases, I unwind a sharply declining stock and take my minor lumps before they exacerbate into a full blown abcess! Does this market reaction make sense to me? NO! Is the economy so different today than in mid January? I don’t think so. All economic reports are at least decent, some very good so I’m hopeful that things will turn around quickly. Perhaps I should start writing some valium prescriptions for some of our institutional friends or ask them to stop worrying about soveriegn debt in Portugal! In any case, it seems that Dave sold the $15 call and rolled down to the $12.50…well done! Given the current market situation, I would wait until Monday or Tuesday at the latest and unwind on any further share loss. I would not in this case and market condition continue to sell options on HEAT in hopes of a price recovery. More on this at a future date and perhaps a full chapter in my next book.
Thank you:
For your kind emails about my latest radio interview. Glad you liked it. For those who missed it:
http://www.blogtalkradio.com/stockgoodies
Click on the arrow in the middle of the page.
Last Week’s Economic News (the sky is falling!):
- The unemployment rate dropped below 10% for the first time since September
- Factory orders rose 1.0% in December, doubling analysts’ expectations
- Personal income rose 0.4% in December, the 6th consecutive monthly increase, although wage growth was a modest 0.1%
- The manufacturing index (ISM) rose to its highest level since 2004, although service sector activity was virtually flat
- For the week, the S&P 500 was down 0.7% for a year-to-date return of – 4.3%
Next Week’s Economic Reports:
- Wednesday: December trade deficit
- Thursday: January retail sales and December business inventories
Video now playing on the homepage:
What Option Premiums Tell us about the Underlying Stock
Wishing you all the best in investing,
Alan
39 responses so far ↓
1 Amy // Feb 7, 2010 at 6:02 pm
Alan,
For years you have been writing that in the money strikes are a more conservative way to invest and that’s what I use for the most part. With this article about delta it really makes even more sense because aside from the additional downside protection it’s also easier and cheaper to buy back the option when the stock price goes down. Great article, thank you.
Amy
2 Dave // Feb 8, 2010 at 3:11 am
Hi Alan,
Thankyou for your article. Its great to have someone share their wisdom and knowledge on such a key topic…
Its been a good learning experience in dealing with this recent market correction. Ive certainly come to understand the influence the market can have our positions and how to best deal with it in the future…
As a result, I have come up with a “market in correction” rule… This rule states that if the following 2 things happen, I will without hesitation SELL the underlying stock…
1) IBD states market in correction
2) Stocks technicals have turned negative
Yes, I may lose a little. But to me, it makes NO sense in fighting the market… The market is bigger and stronger than I am…
Thanks again for the great article!
Dave D
3 Dave // Feb 8, 2010 at 3:20 am
Alan,
Just a question about selling covered calls on the Q’s…
Do you make sure that the Q’s pass the “stock screening test” before you trade them? (For example, that they are trading above the EMA 20 and that the MACD and stochastic are all bulish…)
Thanks
Dave D
4 Don B // Feb 8, 2010 at 11:00 am
Dave D, post #2, Alan –
I read your excellent 2-things rule with wonderment. Sounds great – but how on earth do I find that IBD statement? I looked all over Investors.com to no avail. Noticed too that they offer four weeks free trial, provided I give my credit card number and could call to cancel. Trouble with that sort of deal is that sometimes the hassle of canceling is too much. But $29 a month seems outrageous to me anyway. Shall I try their Monday only special (cost?). Or what would you suggest. Thanx much.
Don B
5 GaryM // Feb 8, 2010 at 1:14 pm
Dave (post 2),
I have been in cash since mid December. I use basically the same criteria as you have imployed. No, I am not trying time the market, but I am will not fight the trend. Once things turn netural to positive I will be the first one in the water as I like to trade OTM CC. Alan would agree that everyone has to be comfortable to themselves with there trading methods.
6 admin // Feb 8, 2010 at 1:36 pm
Dave (comment # 3),
Since, when trading the Qs, we are leveraging 100 stocks, I handle technical analysis in a slightly different manner. Unless the market itself is declining precipitously (as it is now) and not just the normal whipsaws short-term, I want to be invested and in the game. Therefore, a negative chart pattern (with normal overall market conditions) will guide me to selling more or all I-T-M strikes for additional downside protection. When the chart pattern turns around, I opt for more A-T-M and O-T-M strikes. Since I trade multiple contracts in my mother’s account, I am usually “laddering” the strikes with some of each. The chart pattern will dictate which ones I over or under weight.
Alan
7 admin // Feb 8, 2010 at 1:41 pm
Don B,
To locate IBDs assessment of current market conditions:
Go to their homepage: http://www.investors.com
On the top right, go to “The Big Picture”
On the next page, look to the left column, “Market Pulse” in a rectangular box
In this box check for “current outlook”
If you order the “Monday Special” your cost will be about $200 for delivery of 55 Monday editions and 24/7 access to the web site. I have found this to be more than adequate for our purposes.
Alan
8 GaryM // Feb 8, 2010 at 7:32 pm
Note to self (post 5)- proof read your blog text before hitting the SUBMIT button!! Golly. My apologies to the english language.
Alan, thanks for your response to Dave about the Q’s. I am guessing that sector ETF’s could be treated the same way if the sector trend within the overall market trend is positive or negative.
9 Rob // Feb 8, 2010 at 10:01 pm
I have definitely found IBD worth it, even beyond the smartselects and IBD 100. Lots of great things to learn and spot potentials outside the 100.
10 admin // Feb 8, 2010 at 11:47 pm
Gary,
Yes. sector ETFs offer industry diversification with the charts dictating the best strikes to utilize. Use the calculator to assure that the returns meet your goals.
Alan
11 admin // Feb 9, 2010 at 10:11 am
SNI:
This company is scheduled to report earnings tomorrow and analysts have been increasing forecasts and projections over the past 3 months. The stock is trading at a 52-week high despite the market turmoil of late and has outperformed the market by 70% over the past year. Let’s keep a close eye on this one and see how the market repsonds to the report.
Alan
12 GaryM // Feb 9, 2010 at 11:19 am
RMD:
Exceeded earnings estimate by 33% on 2/5. Next Earnings report is 5/7. Beta 0.62, 3 yr. EPS growth rate 21%, All green on Smart Select Ratings, nice technicals. Also, I am using their product for sleep apnea. Best product IMO on the market for CPAP machines for sleeping disorders. Looking at this one for the March options.
13 Don B // Feb 9, 2010 at 12:45 pm
Hello Alan –
Have just been looking over the technicals for both JCG and HMIN. What caught my eye was the fact of the HISTORY of each of these indicators. On JCG, the stochastic shows minus .15, the lowest showing on a one-year chart. The MACD shows at 30, the lowest in one year, yet was almost that low back in March. It reached that low in Sept and almost that low in Nov., and came back up. Shall we ignore the history involved here? Oh, the 200 day m.a. is about 33, and the EMA20 about 39, while the stock is near 38.36 near the close. Similarly, HMIN shows stochastic at minus 2, the only time in a year. The MACD at 20 has hit its number maybe 6X in the last year (very volatile). 200 day m.a. is about 26, while EMA20 is about 31. Stock near 28.70 near closing.
I understand that stochastic below 20 is considered oversold. So how much credence should I be giving to those histories on the charts? Is today all that counts, I suppose would be a better way to put it?
I have positions in both of these, and they are losers. I came in at JCG at 46.31, soldJan 47.50 Calls once, then did BTC. Came in on HMIN at 39.76, also sold Feb 40 Calls once followed by BTC. The age-old question about where to take lumps and where to foresee a turnaround rears its ugly head, I think. Thanx in advance.
Don B.
14 admin // Feb 9, 2010 at 3:16 pm
Don,
Two comments pop into my head:
1- Past history plays a minor role in my trade decisions. For example, if a stock dips below its 20-d ema, I will look back and see what happened the last time or two that occured. Perhaps it went right back up above this MA and then I may lean towards a more bullish approach (keep the stock, look to hit a double). I don’t look at specific historical numbers but a glance at the chart that will be interpreted in seconds. As mutual fund brochures disclaim: past performance does not guarantee…………..So, I would not ignore past chart history but factor it in with the more major parameters.
2- Although I am not privy to the specifics of your trade, I will make the assumption that you executed them on or around January 19th. Pull up a chart of these equities as described on page 85 of CCCs (figure 28). You will note that both stocks have the following in common:
Price bars below the 20-d ema
MACD below zero
Stochastic Oscillator trending down after
breaking through the 80%
Although these stocks may have passed our fundamental screens, their technical health was questionable at best. Factor that in with the general market deterioration and we have a situation where exit strategy execution was essential. I refer you back to the second part of this current article which addresses that issue. When to take your lumps? I take mine when all technical indicators are negative especially when the S&P 500 is declining and the VIX is accelerating. A small lump is much more comfortable than a full blown abscess!
Alan
15 admin // Feb 9, 2010 at 4:28 pm
Mike posted this question by an earlier article. I get many similar, so I thought I would also post it here:
Mike // Feb 9, 2010 at 1:40 pm
Alan—
I have a question calculating yields. I’ve calculated yields for a long time and recently checked my figures against your calculator and am confused.
For ITM options you subtract the buydown from the original investment since this reduces the out of pocet expense. I agree but wonder why you also don’t subtract the actual op;tion profit ( total minus the intrinsic) from the original investment since this also reduces out of pocket expense. Anything you can do to reduce the original expense will increse the yield.
Also- when calculating the ATM or OTM options you do not subtract the premium from the original investment. Doesn’t this also lower the out of pocket expense?
Thus if I buy $10,000 of stock at $100 /share and sell the $100 strike @ $6.oo. My original investment is $ 10,000 – $ 600 = $9,400 and I would calculate my yield at 600 / 9400 = 6.4 %
If I don’t reduce my original investment by the premium received, it’s 600/10,000 or 6 %.
It’s not much difference, but I keep wondering about it.
Thanks for all you do.
Mike
My response:
Mike,
We have 2 questions here:
1- You are using the $600 profit two times: once to lower your cost basis and once to generate profit. That’s $1200 ! Let’s say instead of buying stock, you purchased a 6% bond. At the end of the investment period, you have $10,600, a 6% profit.
Now, you buy $10k in stock , sell a call for 6%and the price remains the same through the investment period. Your bottom line is $10,600, also a 6% profit. If you lower your cost basis and take the profit, the calculation would be 6.38%, an incorrect result. If this were our return, we should have $10,638…we don’t!
2- The equations I use in my calculator are a little tricky because I come from the perspective of making money, not breaking even. Since our real profit is the time value of the option premium, I deduct the intrinsic value of I-T-M strikes and use this cash to reduce my cost basis. Therefore, my calculator shows the initial profit, upside potential for O-T-M strikes and downside protection for I-T-M strikes. In my view, this portrays a clearer vision of your option position while managing through the contract period and also allows for a better breakdown when deciding on which strike to select. Simply calculating a breakeven gives less information and a more negative philosophical approach to the strategy. Those who use premiums to lower cost basis and then compute profits at the end of the contract are not wrong (but you can’t use the option profit for both), just looking at it differently with less information.
Alan
16 Dave // Feb 9, 2010 at 5:52 pm
Hi Alan,
A question about selling calls on the Q’s…
If I was to buy 100 shares of the Q’s, and did not intend on puchasing any more, is it wise to purchase them ALL at once?… Hence, I wouldnt be following the approach of dollar cost avaraging in this approach…
Thanks Alan…
Dave
17 admin // Feb 9, 2010 at 6:42 pm
Dave,
I encourage dollar cost averaging into an ETF when that position represents a significant portion of the total portfolio. Many BCIs are starting with small portfolios and I want that hard-earned money protected as much as possible. By DCA into an ETF, the average cost will be less than the average price over the investment time frame. If 100 shares of the Qs represents a small portion of the total portfolio, DCA becomes less important.
Alan
18 Dave // Feb 9, 2010 at 8:29 pm
Alan,
Also, with the Q’s, do you apply all the same exit strategies as you would with any other stock? Or do you give it ’special’ consideration bacause its the Q’s?
Thanks ALan
Dave
19 admin // Feb 10, 2010 at 3:30 am
Dave,
Exit strategies for ETFs (including the Qs) is handled in the same manner as individual equities. However, because of the lessened implied volatility associated with a basket of stocks, there is much less opportunity for these exit strategies, with the exception of expiration Friday rolling options.
Alan
20 admin // Feb 10, 2010 at 6:47 am
WRLD:
On January 28th reported a record fiscal 3rd quarter earnings surprise. Revenues are up 13% year-to-year as analysts project 19% earnings growth in 2010. Fundamentals are strong with a forward PE ratio of 8.6x and ROE of 22% with a Price/book of 1.76.
Check to see if this equity deserves a place on your watch list.
Alan
21 Eric R. // Feb 10, 2010 at 11:21 am
Hi Alan –
Thanks for your recommendation in your book to diversify by several positions and by sector. I had to take some “lumps” recently, but it wasn’t as bad as it could have been had I not diversified properly.
Question about the IBD 100: I know we are in a correction now, but when the market confirms a new rally IBD will list many stocks with a black border around them to note they are close to a buy point. You mention the black border in passing in your book, but I was wondering if you give the black bordered stocks any special consideration.
Thanks for your time and keep up the good work
Eric
22 admin // Feb 10, 2010 at 12:18 pm
Eric,
For those not familiar with this IBD 100 feature:
In the IBD 100 charts section, a few will be highlighted with a black border. These are stocks IBD considers giving extra consideration because of the “basing” pattern of the chart. Many technicians believe that charts with strong bases (having consolidated for some time) and strong fundamentals may be ready to head for the moon.
Over the years, I have not noticed these stocks to be better candidates than the others as screened by the BCI system. I certainly would not ignore them, nor would I walk them to the front of the line.
Alan
23 Don B // Feb 10, 2010 at 4:08 pm
Alan -
Your post #20 about WRLD was fabulous and also quite interesting. Isn’t this an instance in which the fundamental issues and the current market situation are in a sort of clash? By that I mean we must ask ourselves what has been one of the most trying elements affecting finance today? Debt, of course. So here we have a stock that looks fabulous, but is involved in one of the biggest problems going. I don’t want to be a bother but your perspective will sure be desirable. TIA.
Don B.
24 admin // Feb 10, 2010 at 5:16 pm
Don,
Thanks for your post. I probably should have expanded on my original post # 20. Certain companies just have an “angle”. When I noticed analysts jumping on this bandwagon, I did a little investigating.
WRLD provides SHORT-TERM (average 11 months) loans and insurance products to INDIVIDUALS with an average loan being about $1000. In 2009, it loaned $1.9 billion in 1.9 million transactions!
It also operates ParaData Financial Systems, which provides computer software in 1465 consumer loan offices. That’s their angle and it’s working.
Alan
25 Dave // Feb 10, 2010 at 8:12 pm
BWLD:
Even due to the current market correction, this stock has passed ALL the fundemental and technical BCI screens with flying colours…
Its due to release a earnings report on the 11th (which is today) so we’ll see how it goes…
Ive popped it on my watchlist…
Dave
26 GaryM // Feb 11, 2010 at 9:33 am
Dave (post 25):
I have been watching BWLD as well. Stock looks like it is a little overbought right now. But I will be watching this for a March CC play. Thanks for sharing.
27 Rob // Feb 11, 2010 at 9:38 am
Dave,
I took a look and the macd and histogram have slight negative divergence. But it is only slight. I am going to keep an eye on it too. Thanks for the tip.
28 admin // Feb 11, 2010 at 2:13 pm
CLB:
At the time of this post, this equity does NOT meet our system criteria but it is worthy of discussion.
Two things that catch my attention are when companies increase or announce dividend distribution and when a stock split is announced after a significant run-up in price. Both events occured with this equity when it reported earnings after the bell last night. The dividend was increased by 20% and the Board of Directors proposed a 2-for-1 stock split, payable on or about July 7th, pending shareholder approval. I consider this a valid split since the stock has appreciated substantially over the past several months.
You will note that CLB just misses passing the SmartSelect screen due to EPS Rating. That may change after the recent positive ER, I’m keeping an eye on that. You will also note that there is no Scouter rating for this stock since it is an ADR, a company that has its base in the Netherlands. ADRs are still eligible in my system if all other criteria are met. Worth monitoring this one.
Alan
29 Barry Bergman // Feb 11, 2010 at 2:31 pm
Dave,
Please keep a watch on BWLD. They just reported earnings and had a miss. Stock is being hit in after hours trading.
Barry
30 Dave // Feb 12, 2010 at 2:56 am
Hi Barry,
Yes, I will keep an eye on BWLD and watch how this stock behaves…
Thanks,
Dave
31 admin // Feb 12, 2010 at 3:48 am
PRGO:
Recently reported record (2nd) quarterly earnings and revnues in addition to record cash flow. The company increased guidance and analysts are behind this equity. Also, it recently declared a quarterly dividend with an industry-leading yield of 0.55%. During the past year, PRGO has outperformed the S&P 500 by 50%.
Check to see if this equity has a place on your watch list.
Alan
32 Dave // Feb 12, 2010 at 4:30 am
I checked out the chart of PRGO… While the rest of the market was in a correction this stock seems to have ‘headed to the moon’…
Thanks Alan…
Dave
33 Dave // Feb 12, 2010 at 7:31 am
Barry, you were spot on about BWLD… The stock gapped down big time!
Alan, THANKS for warning us NOT to invest during earning reports… You just saved me $$$
34 Don B // Feb 12, 2010 at 8:50 am
Seems like there is a learning experience right here with WRLD. Started watching just a few days ago, did not move on it, fortunately. But the question in my mind now is, Have we been presented here with an opportunity? Has the market re-acted to the ER rationally, or irrationally? Is this merely a new level at which to function? No, I am not asking for a crystal ball, rather I feel inquisitive about how best to approach this. TIA.
Don B
35 Don B // Feb 12, 2010 at 8:53 am
PS = I meant BWLD in my last post #34.
Sorry.
Don B
36 admin // Feb 12, 2010 at 9:10 am
To all,
With the recent posts conerning ERs I thought I’d share this FREE site that offers info on earnings surprises, both positive and negative along with reports that met expectations:
http://biz.yahoo.com/z/extreme.html
Regarding Don’s excellent observation about the possible irrational over-reaction to the ER for BWLD:
I had been giving this equity strong consideration for the March contracts. However, there is no need to make a decision at this point. We can re-evaluate the chart pattern in the first week of the next cycle. Our returns will not be significantly negatively impacted and our risk will be reduced. If the chart pattern is mixed, I may consider an I-T-M strike. If the pattern turns positive and the market stabilzes, I will look to the O-T-M strike. As always, if we have multiple contracts we can “ladder” our strikes and do some of each. Calculations also play a role in our final decisions. Also, recheck the fundamentals which may change after an ER.
Alan
37 admin // Feb 13, 2010 at 9:24 am
Have your options ever been exercised early? Your shares sold unexpectedly? Situations like these are rare but DO occur. In my next journal article we will discuss the why and when of
these scenarios and what we, as CC writers, can do about them.
Alan
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