Understanding option calculations is an integral part of the BCI methodology. Using the Ellman Calculators (Basic and Elite versions) will facilitate the process but knowing the “how” and “why” of these numbers will make us all better investors.
This article was inspired by Peter, one of our members. He was concerned about the potential drop in share price of a covered call trade he was in and wanted to calculate future returns based on the current delta of the option. Before I set up the trade for you let’s define delta:
The amount an option value will change for every $1 change in share price. Delta values run from 0 to 1 and the greater the chance that the strike will end up in-the-money, the higher the delta (the closer it is to 1).
Here is Peter’s trade from several months ago so I will use our generic BCI as the stock and 1 contract for simpler math:
- Buy 100 x BCI @ $62.46
- Sell 1 x $55 call @ $9.75
- Current share price is $60.06
- Current “ask” for the $55 call is $9.85
- Delta for the $55 call = 0.68 (moves $0.68 for every $1 move in share price)
Peter’s initial returns using the multiple tab of The Ellman Calculator:
We see an impressive 1-month return of 4.2% (time value only) and protection of that profit of an also impressive 11.9%
***A free copy of the Basic Ellman Calculator and its user guide can be downloaded from the “free resources” link on the top black bar of this page.
Calculating future returns using delta:
Peter was wondering what his position would be if share price dropped by $2 in the next week. Let’s calculate using delta with the understanding that there are other factors that will influence option premium like time value erosion (theta) and changes in implied volatility of the underlying security (vega). So all other factors remaining about the same, the delta of 0.68 will cause option value to decrease by $1.36 (2 x $0.68) when share value drops to $58.06. That means the cost to close (“ask”) will be $8.49 ($9.85 – $1.36). Okay everybody, take off your shoes and socks and let’s calculate this hypothetical circumstance:
- Share loss = $4.40 ($62.46 – $58.06)
- Option credit = $1.26 ($9.75 – 8.49)
- Net debit = $3.14 per share or $314 per contract ($4.40 – $1.26)
The takeaway here is that if Peter closes his entire position given this hypothetical scenario, he would lose $314 per contract. So where would he be if he didn’t close?
To close or not to close:
Unless some egregious news has come out about the company in question, Peter is still in great shape in this trade. The deep in-the-money strike sold ($55) generated an 11.9% downside protection of the time value component of the original option sale (4.2%). This means that Peter was guaranteed a 4.2% 1-month return as long as share value did not decline below $55. Even if the $2 drop in share value does occur, there is still another $3.06 in downside protection protecting that profit. At this point, the trade is still a classic “take no action” situation again as long as there was no unusual news reported by the company.
When do we start losing money:
Well we always have our exit strategy arsenal in place to avoid or mitigate losses but our breakeven is always share price – total option premium. In this case:
$62.46 – $9.75 = $52.71
With the stock currently trading at $60.06, even a share drop of $2 will leave us a galaxy away from the breakeven. Sometimes the best action to take is no action at all.
Next live seminar: Coral Springs, Florida: Just added:
I will be in SE Florida for 11 days in early September attending to family real estate business and was invited to speak at a local options club which meets 15 minutes from where I’m staying. As many of you know, I’ve never met a microphone that I didn’t want to speak into when it comes to covered call writing, sooooo….
South Florida Options Trading Forum
Thursday September 11th
Ask Alan videos:
Just a reminder that new Ask Alan videos will be posted on the blog the 2nd Wednesday of each month with some additional videos available on the general site and the entire set available on the premium site. These changes are currently being set up by my outstanding team members.
It appears that the recent market volatility is related on geo-political events occurring in the Middle East and increasing tension between the US and Russia. It certainly cannot be blamed on this past week’s economic reports which continue to be positive:
- According to the Labor Department, the annualized rate of non-farm productivity (a measure of the growth of labor efficiency in producing the economy’s goods and services) rose by 2.5%. Year-over-year, productivity was up 1.2%
- Initial jobless claims for the week ending August 2nd came in at 289,000, less than the 302,000 expected
- According to the Institute of Supply Management, the ISM Non-Manufacturing Index rose to 58.7 in July, showing continued expansion and at the highest level since 2005
- Consumer credit (excluding mortgages) increased by $17.3 billion in June according to the Federal Reserve. This is a report of the dollar value of consumer debt, including categories such as credit card use and store charge accounts (known as revolving debt) as well as longer-term loans for autos, education, recreation vehicles, etc. (known as non-revolving debt). The level of consumer credit is considered a barometer of consumers’ financial health and an indicator of potential spending patterns. This represents an increase of 6.5% year-over-year
- According to the Commerce Department, new orders for manufactured goods rose by 1.1%, well above the 0.6% anticipated. Factory orders were up 2.5% year-over-year
- The US trade deficit decreased by 7% in June to $41.5 billion, narrower than expected and a result of stronger growth in the 2nd quarter
For the week, the S&P 500 was up 0.3%, for a year-to-date return of 6%, including dividends.
IBD: Market in correction
GMI: 1/6: Sell signal since market close August 4, 2014
BCI: Moderately bullish but continuing to favor in-the-money strikes while the market digests the events alluded to above.
Wishing you the best in investing,
Alan ([email protected])