There are several factors that allow us to estimate the risks associated with our option positions. Together, they fall under the heading of the “greeks” because most of them are named after Greek letters. Let’s first look at the major forces that impact a call option’s price:
- An increase in volatility will increase an option premium
- An increase in time-to-expiration will increase the premium
- An increase in the underlying share price will increase an option’s price
- A decrease in the above factors will result in a decrease in option value.
The major Greeks:
Delta: Price sensitivity. The most commonly used greek measures how much the theoretical value of an option will change if the underlying value of the stock moves up or down $1. The delta of a call can range from 0.00 to 1.00. The closer an option’s delta is to 1.00, the more the price of the option responds like the underlying stock, when the stock price moves. For example, if company BCI is trading at $38/shares and the $40 call is selling for $2, with a delta of .50, the following would be true if all other factors remain constant:
- If BCI increases to $39/ share, the $40 call would increase in value to $2.50
- If BCI decreases in value to $37/share, the $40 call would decrease in value to $1.50
- In other words, for every change of $1 in share price the option value changes by one half that amount.
Gamma: Second order price sensitivity. The rate of change for delta with respect to the price of the underlying security. It is an estimate of how much the delta of an option changes when the price of the stock moves $1. When an option is deep in-the-money or deep out-of-the-money (several strikes above or below the market value of the stock), the gamma is small. When the option is near the money, the gamma is the largest. Gamma is used when trying to gauge the price of an option relative to the amount it is in or out of the money.
Theta: Time sensitivity. It is a measure of the rate of decline of an option due to the pasage of time. An option will lose value as it moves closer to expiration Friday if all other parameters remain constant. Theta has a greater impact on options with fewer days to expiration than those with more days to expiration. You will note on the charts presented in my most recent book, Exit Strategies for Covered Call Writing, the option value literally falling off a cliff towards the end of the contract period. This is theta at work. Theta will NOT impact intrinsic value, but rather the extrinsic or time value.
Vega (the only “Greek” not represented by a real greek letter): Volatility sensitivity. The amount that the price of an option changes compared to a 1% change in volatility. Higher volatility means higher option prices. This is because the greater volatility brings with it larger price swings and more likelihood of an option to make money. Vega is highest for A-T-M calls and lower as options delve deeper I-T-M and O-T-M. Vega also falls as the option gets closer to expiration.
Practical application:
1- Delta and Gamma are first and second order price sensitivity measures. When a strike is in-the-money, the delta is about 1.00. A move up of $1 in price will represent another dollar of downside protection. A decline in share price of $1 will decrease our protection by that same amount. If we are especially concerned about a declining share price or market volatility, we may want to get as deep in the money as possible (still receiving a decent return), since protection erodes dollar for dollar of intrinsic value at these levels. To review the option premium formula:
Premium = Intrinsic value (amount in-the-money) + time value (including volatility)
2- Theta represents time sensitivity. Since we are selling predominently 1-month options, time is limited to begin with. During the final two weeks of a contract period, option value literally falls off a cliff. It’s difficult to generate the kinds of returns we are seeking if we wait for the final two weeks. Because of the threat of theta, we should look to sell our options during the first week of a 4-week contract period and the first two weeks of a 5-week contract period. Theta is also the reason I created the rules of paying less to buy back an option during the latter part of the contract cycle than in the earlier portion of that time frame when executing exit strategies.
3- Vega represents volatility sensitivity. We all love great, big, juicy returns. The more the better, right? WRONG!
If delta, gamma and theta remain constant but the option premium returns much more than the 2-4% per month we seek, we know vega is rearing its ugly head. Volatility means risk. The stock can go up a lot but it also can decline dramatically in a short period of time. When I see a 6-7% 1-month return for a 1-month option, I check the chart and usually see a major roller-coaster pattern. No thank you, I’ll pass for the steady uptrending safer moving averages. Many of you who read, Cashing in on Covered Calls, may remember my story about Taser and how I learned my lesson to avoid these volatile companies.
The bottom line is that it’s not essential to memorize the definitions of the greeks (unless you’re going to appear on Jeopardy). It is helpful, however, to understand the concepts of how price, time and volatility play into the value of our option premiums and what that says about the nature of the underlying equities.
Last Weeks Economic News:
The impact of the global recession and lower energy prices were reflected in lower consumer prices and industrial production (down by 1.1% in May). Signs of recovery, however, included a surge in new residential construction (up 17.2%) and a rise in the Conference Board’s index of leading economic indicators (up 1.2% in May). For the week, the S&P 500 declined by 2.6% for a year-to-date return of 3.3%.
Stocks on the Move:
On the home page of the IBD website is a list called Stocks on the Move. These are stocks that were up in value for the day on higher than normal volume. This is oftentimes indicative of the institutional players taking positions in these equities. This is of great interest to us as we would like to join the party. Three of the stocks from Fridays list met our system criteria:
- FUQI
- PWRD
- TNDM
FUQI was already on my watchlist so I added the other two. Here is the chart of FUQI as of the penning of this article:
FUQI as of 6-19-09
Looking at FUQI, I noticed some interesting option choices.If we purchased this stock near closing on Friday, we would pay $17.63. Usually, we would look to the $17.50 strike:
ROO = 190 - 13/1750 = 10%
Downside protection = 13/1763 is negligible.
This return reminds us of the above discussion of vega. The market is expecting volatility with this equity perhaps because of the huge run-up it has had lately. How can we reduce this risk and still use this financial soldier? I checked the $15 call:
ROO = 330 – 263/1500 = 4.5% 1-month return = 54% annualized
Downside Protection = 263/1763 = 15%
With vega telling us that we are prone to a volatile, risky investment, why not go for the still great 4.5% 1-month return and a fabulous 15% insurance policy (paid for by the option buyer!).
Videos now playing on the homepage:
What Option Premiums Tell us about the Underlying Stock and more….
My best to all,
12 responses so far ↓
1 EVAN // Jun 21, 2009 at 8:50 pm
Comments:
I am so delighted with your books…easy to follow and good commonsense
The 17.50 call on FUQI has at least a 10% cushion of safety…was that a typo or did I misunderstand?
Finally, how did you fare with the deep decline in 2007 and 2008. What is your best defense…this is critical to me. You were fully invested at the time per your book.
Besides picking great stocks, I mostly write ITM calls (with 15-20% downside protection, buy back the calls and sell the stock if the strike price is traversed (ITM calls) and buy OTM SPX puts (15-20% OTM) based upon my total covered call portfolio…what do you think?
I am not worried about doing well in flat or up markets…I am worried how to protect my portfolio and mind during markedly down markets…no risk, no goodies but advance preparation might pay off….your thoughts please.
Thanks for a job well done,
Evan
2 Dave // Jun 21, 2009 at 8:53 pm
The link to the video isn’t working for me.
3 admin // Jun 22, 2009 at 12:17 am
Evan,
Thanks for your comments about my books. Now for my comments about your questions:
1- As of Friday’s close, the option return for the July $17.50 call was $1.90. If shares are assigned there is a .13 loss in the sale of the stock (17.63 – 17.50) making the real profit $1.77. If we divide this by the “bought-down” value of the stock ($17.50) our 1-month profit is 10.1% if the stock price remains above the strike BUT with little downside protection.
2- 2008 was a highly unique market that few investors have seen in there lifetimes. The collapse in our economy sparked by the sub-prime debacle impacted all areas of investing. I turned my stock portfolio into cash part way through 2008 based on a soaring VIX (went as high as 90!) and a plummeting S&P 500 chart pattern. Figure 1 on page 4 of “Cashing in on Covered Calls” tells you to “get out of stocks” when this occurs. In a moderately declining market I turn to I-T-M strikes, something you are already doing.
3- Regarding your system of selling deep in-the-money calls and buying out-of-the-money puts:
(For our readers not familiar with the “put” aspect of your system, a put is the right to SELL 100 shares at a certain price; an O-T-M put is where the strike is BELOW market). I would paper-trade until I have the following questions answered to my satisfaction:
- What is my actual REAL PROFIT generated by selling these deep in-the-money calls if the shares are assigned? The deeper you go i-t-m, the lower the real profit.
- What is the impact on my portfolio of buying o-t-m puts if my stock is declining but the market in general is accelerating?
- How do my portfolio returns compare to that of the market in general (S&P 500)?
Having read my books, you are familiar as to how I handle declining stocks in different market conditions.
In general, I respect your conservative approach, we ceratinly think alike in this regard.
Alan
4 admin // Jun 22, 2009 at 12:20 am
Dave,
Here is a direct link to the curreent video on YouTube:
http://www.youtube.com/watch?v=mCEVR9c0zs8&feature=channel_page
Alan
5 Barry Bergman // Jun 22, 2009 at 6:52 pm
alan,
Here are the stocks that passed the BCI filters as of 6/20/09 (when the new IBD100 was available:
BJRI
CERN
CRI
FUQI
GMCR
HDB
MFE
NEU
NFLX
NTES
PWRD
RHT
STAR
STEC
SYNA
TKLC
VPRT
VRX
The charts and indicators were a bit hard to interpret this cycle (a number of stocks were right at the MAs or the indicators were mixed), but these are the best of what was available.
Did you ever have a chance to look at Navellier’s “Stock Grader”? He just changed his format a bit but all the information is available at no cost…just a little more digging. I was wondering about your thoughts of using all 3 of the current indicators (Overall/Quantitative/Fundamental), i.e.: A-A-A, as another screen to “bullet proof” the system. The only downside as I see it is that we may be too tight and miss a good strock here and there. For this week’s selections…RHT and TKLC…would not have passed the Navellier A-A screen.
The best,
Barry
6 admin // Jun 23, 2009 at 10:59 am
Barry,
Thanks again for sharing your suggestions with our group. Those who follow this blog on a regular basis know that Barry is a sophisticated investor who puts a lot of time and effort into his due-diligence.
The “stock grader” (http://www.navellier.com/tools_research/log_in.aspx) is an additional screen that Barry uses when locating covered call candidates.
I did look at it and it does look like a quality screen that encompasses many of the critical parameters we require before selecting a cc candidate. I have not had a chance to do a long term analysis to determine whether adding this screen will enhance our system.
As you know, I am a proponent of thinking outside the box and encourage new ideas. I also locate stocks other than those on the IBD 100 (stocks on ther move list, canslim list, top pertformers in industries in favor, walk into a restaurant you like etc).
If time permits, you can locate “A” stocks from this screen and then run them through the BC system. I’m sure there will be gems found that otherwise would not have been uncovered.
Alan
7 admin // Jun 24, 2009 at 7:34 am
PWRD:
I sold the I-T-M $25 call for a 1-month 2.5 return and a significant downside protection. The stock has gone up in value and is now trading @ $5.33 above the strike. Covered call writers have to view share appreciation in this case as a benefit. You are enhancing your protection of the 2.5% return. There are still 31/2 weeks left until expiration Friday. That protection could come in handy later in the contract cycle.
Alan
8 admin // Jun 25, 2009 at 8:51 am
The coal industry is heating up (sorry about that!). Keep an eye on our old friend WLT which is about to meet our system criteria once the chart pattern improves.
Alan
9 Susan // Jun 25, 2009 at 10:56 am
I had most of the stocks on Barry’s list. here are a few more:
aan
wms
tndm
urs
good luck to everyone.
Susan
10 admin // Jun 27, 2009 at 6:36 am
There are some major changes taking place with EXCHANGE-TRADED FUNDS (ETFs). We must be aware of this information before investing with some of these funds. Don’t miss my next journal article which discusses this matter and more.
Alan
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