When studying option trading basics and the Greeks we learn about our 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, 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 to1.
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 in-the-money. In the scenario where we sold a $50 call and the stock was trading @ $70 with one week remaining, the delta would 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 $0.50, 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 chances of that $50 strike ending up I-T-M are 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:
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, strike price and stock price
Delta vs. Strike Prices
Factors influencing delta:
1- Stock price– As we can see from the above figures, an increase in stock price (red arrow) moves the strike towards I-T-M status and the delta will increase.
2- Time– Delta will change as we approach expiration Friday. I-T-M strikes will show increasing deltas because of the higher likelihood of ending with intrinsic value (less time to move O-T-M). O-T-M strikes will show decreasing deltas because of the lower likelihood of turning things around and ending up I-T-M.
What delta teaches us about risk when selling covered call options:
We learn why O-T-M calls present more risk. These calls have low deltas. If the stock drops in value, the option price will decline at a much slower pace (because of the low delta). This will make it more expensive to buy back the option if we are looking to institute an exit strategy and/or close our position.
Summary:
Deltas measure the probability of an option ending I-T-M, or stated differently, with intrinsic value:
- 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 close our positions.
- 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.
Next live event:
American Association of Individual Investors- Chicago Chapter:
Saturday, November 10th
10AM to 11:30 AM
DePaul Center
Market tone:
This was a light week for economic reports but good news on the real estate front:
- Sales of new homes rose by 7.8% in August
- The median price of existing homes rose to $187,400 in August, the first time prices have increased for 6 straight months since December, 2005 to May, 2006
- The time needed to deplete entire inventory of homes fell from 6.4 months to 6.1 months
- Construction of new residential homes rose by 2.3% in August as housing starts are 29% higher compared to a year ago
- The Conference Board’s index of leading economic indicators fell by 0.1% in August as anticipated. The index is still up 1.5% compared to a year ago
Summary:
IBD: Confirmed uptrend
BCI: Cautiously bullish using an equal number of in-the-money and at-the-money strikes. I am not as confident in the upcoming earnings season as I have been the past year.
Thanks for your incredible support.
Alan ([email protected]
Premium Members,
The Weekly Report for 09-21-12 has been uploaded to the Premium Member website and is available for download.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:
http://www.youtube.com/user/BlueCollarInvestor
Best,
Barry and The BCI Team
Alan, I have some questions about your premium reports of which I would most likely use, seeing as these would be a big timesaver for me to find the appropriate stocks. So what I am wondering is:-
1. If I buy a share that is listed on the premium report to make a trade, and then the next week or so this share isn’t on the list, then do I need to close my position and sell my share or can I keep it until expiry?
2. If I am wanting to subscribe to your premium report while I am trading, then do I need to subscribe to it for papertrading first, – or can I just practice on any shares(that aren’t on this report)?
3. And when subscribing to the report, then does this now mean that I wouldn’t need to do any technical analysis at all for any shares held(or only for our monitoring positions)? Thanks
Adrian,
My responses:
1- Once you enter a covered call position from a stock on the premium watch list, it is managed by the same BCI methodology as set forth in my books and DVDs whether it is on the next week’s list or not. Stocks tend to whipsaw and a stock may pass the screen one week and just miss it the next, yet remain a viable candidate., That’s why we leave stocks on the report (possibly in “failed current week” section) until it has misses3 weeks in a row.
2- Once you have made a decision as to the resource and methodology you will be using I would highly recommend paper-trading with that precise resource. When my team publishes the weekly reports the first thing I do is print it out and place it in 2 sheet protectors. One for the weekly stock screen and the other for the “running list” which is my only watch list. This gives me easy access to the information I need to enter new positions and manage current ones.
3- The BCI team does a full technical analysis of ALL stocks that have passed the fundamental and common sense screens . Many are eliminated if they fail the technical screens and the ones that pass have earned their way onto our “running list” Keep in mind that this technical analysis is as of 4PM EST on Friday. I WOULD briefly re-check the technicals if you enter a new position late in the week. Set up a technical chart and save the link. Then once you access that link you simply have to enter the ticker and evaluate the chart in seconds. If you enter a new position early in the week, no need to do a technical analysis.
Alan
Alan,
Aside from delta do you use any of the other greeks in your trading decisions? Thanks for an interesting artcile.
Kevin
Kevin,
It’s not necessary to look up the specific greek stats but it is useful to understand the concepts of how they impact our option premiums. Options with high Vegas (the only “Greek” not represented by a real Greek letter) ay be too risky for conservative covered call writers so I set my 1-month goals with a 2-4% return. Those with higher or lower risk tolerance can adjust accordingly. Also, understanding theta and time value erosion will dictate our entry and exit points which will go a long way in maximizing returns. In the BCI methodology education is paramount but we also avoid analysis paralysis.
Alan
Alan, that answer to No.2 above sounds like a good way of studying this report. Print it all out and then evaluate the stocks from there. I was originally thinking of doing this so as to reduce the amount of time spent on the computer. My last questions about this report I ask:-
1. On p.440 of your book there is a ‘running list’ shown, but how do I go about selecting the stocks I want from this list? I am just wanting to use 5 stocks, but by what order of these categories am I to use?
2. If the market is trading sideways then is it best for me to pick 5 stocks with a beta around ‘1.0’, or does it not matter so much how I pick them?
3. And after having read all your books and now currently looking at share charts on computer, is there anything you can suggest that I can do in the time I am not on computer?, should I print out some share charts to look for buy/sell points on them or something else.(just feeling a bit bored, but know I should do more!)?
I will be doing a bit of tech.analysis for a while now. I have learnt quite a bit now, and it is good to be able to get most things I don’t know answered here. I don’t know where else I could have! Thanks
Adrian,
As you can see, there is a lot of critical information found in these reports. Our members use this information in different ways. Let me give you some EXAMPLES as to how one can reduce the list:
1- Check pages 1 and 2 of the report to eliminate stocks that may be too costly for a portfolio (AAPL?).
2- Many of our members start with stocks in “bold” indicating the greatest fundamental and technical strength at the time the report was generated.
3- Stocks with industry rank of “A” can be favored
4- For a 5-stock portfolio, select only one stock from a particular industry
Beta plays a larger role in a raging bull or bear market. In a sideways trading market this would not be a significant factor.
After establishing your watch list, it would be productive to follow the news of the day, especially the economic reports. You will note that I summarize these reports at the end of my weekly blog articles for those not able to access these reports during the week.
Alan
Running list stocks in the news: BIIB:
On July 24th, Biogen Idec reported another stellar 2nd quarter earnings report. Earnings were up 34.8% year-to-year, 16.7% above consensus. Revenues increased by 17.6% year-to-year assisted by sales of Avonex, a multiple sclerosis drug. BIIB has had positive earnings surprises in 6 of the last 8 quarters with an average beat of 5.6%. As a result Biogen has raised estimates with long-term earnings growth projected @ 14.1%. Our premium “running list” shows an industry segment rank of “A” and a beta of 0.83.
Alan
Locating the Greeks:
In response to a few requests, the BCI team recently uploaded a brief tutorial on the premium site as to how to obtain information on the Greeks for specific options. Look in the “resources/downloads” section for “GREEKS: How to locate stats”
Alan
Running list stocks in the news: KORS:
On August 14th, Michael Kors released an outstanding fiscal 2013 1st quarter earnings report with earnings up 161.5% year-to-year, a 70% earnings beat. Revenue rose by 71% year-to-year, gross profit was up 83% and operating income grew by 149%.
On September 20th, KORS raised fiscal 2013 earnings and sales projections based on comparable same stores sales of 30% which are up 45.1% quarter to date. The company boasts a trailing 12-month ROE of 33% compared to its industry peers’ 19.7% indicating how efficiently it re-invests earnings. Our premium “running list” shows an industry segment rank of “B” and a beta of 1.11.
Alan