For covered call writers and put-sellers, the option Greeks play a major role in our understanding of the risks and value of our option premiums. We know our option premiums consist of intrinsic value (for in-the-money strikes) + time value. Our initial time value returns reflect the time to expiration + the volatility of the underlying security. When comparing option contracts that expire on the same date, the distinguishing factor becomes the implied volatility of the underlying stock or exchange-traded fund. A second factor that interests option-sellers is the probability of an option expiring in-the-money. When an option expires in-the-money, we have maximized our returns for that position, a positive outcome. However, other covered call option sellers may view this as a negative in that exercise may not be a desired outcome. Delta is an option Greek that can be defined in several ways but one popular definition is that it represents the likelihood of an option expiring in-the-money. Delta values run from 0 to 1 for call options and from 0 to (-)1 for put options from the perspective of option buyers. This article will highlight the relationship between implied volatility and Delta.
Definitions
Implied volatility: This is a forecast of the underlying stock’s volatility as implied by the option’s price in the marketplace.
Delta: The percentage likelihood that, upon expiration, the option will expire in-the-money or with intrinsic value. For additional definitions of Delta, click here.
The impact implied volatility has on Delta depends on the moneyness of the strike
On page 29 of my E-Book, Option Greeks Analyzed for Retail Investors, I show a chart which reflects the following relationships:
ITM (in-the-money)strikes
- Lower volatility results in higher Delta
- Higher volatility results in lower Delta
OTM (out-of-the-money) strikes
- Lower volatility results in lower Delta
- Higher volatility results in higher Delta
ATM (at-the-money) strikes
- Higher and lower volatility has little impact on Delta
Generic chart showing the relationship of implied volatility and Delta for different strike prices
For a stock trading near $45.00, the Delta statistics would look similar to those in the chart below which shows implied volatilities of 25, 54 and 85.:
How Changes in Implied Volatility Impacts Delta
Key to chart
- Pink field: IV stats
- Yellow field: In-the-money strikes
- Gold field: At-the-money strikes
- White field: Out-of-the-money strikes
Discussion
Whether our goal is for the sold option to expire in-the-money or out-of-the-money, it is important to understand the impact implied volatility will have on Delta or the probability of this outcome. The information presented in this article can be summarized as follows:
- Higher implied volatility lowers the probability of an ITM strike expiring in-the-money (Delta decreases)
- Higher implied volatility increases the probability of an OTM strike expiring in-the-money (Delta increases)
Upcoming events
Denver Colorado: American Association of Individual Investors
August 18 @ 9:00 am – 12:00 pm
Saturday August 18, 2018
Click for information and registration details
San Francisco Money Show
August 23 @ 10:00 am – 11:00 am
Hilton San Francisco Union Square
1.Thursday August 23rd: 11:30 AM – 12:15 PM
All Stars of Options: How to Select the Best Covered Call Options in Bull and Bear Markets
2. Friday August 23rd: 10:15 AM – 1:15 PM
Masters Class: How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using 2 Low- Risk Option Strategies (covered call writing and selling cash-secured puts)
Market tone
This week’s economic news of importance:
- Existing home sales June 5.38 million (as expected)
- Markit manufacturing PMI flash July 55.5 (55.4 last)
- Markit services PMI flash July 56.2 (56.5 last)
- New home sales June 631,000 (660,000 expected)
- Weekly jobless claims 7/21 217,000 (219,000 expected)
- Durable goods orders June 1% (3.7% expected)
- GDP Q2 4.1% (4.2 expected)
THE WEEK AHEAD
Mon July 30th
- Pending home sales June
Tue July 31st
- Personal incomes June
- Consumer spending June
- Core inflation June
- Case-Shiller home price index
- Consumer confidence index July
Wed August 1st
- ADP employment
- Market manufacturing PMI July
- ISM manufacturing index July
- Construction spending June
- FOMC announcement
Thu August 2nd
- Weekly jobless claims 7/28
- Factory orders June
Fri August 3rd
- Non-farm payrolls July
- Unemployment rate July
- Average hourly earnings July
- Trade deficit June
- Markit services July
- ISM non-manufacturing index July
For the week, the S&P 500 moved up by 0.61% for a year-to-date return of 5.43%
Summary
IBD: Market in confirmed uptrend
GMI: 6/6- Bullish signal since market close of July 9, 2018
BCI: Using an equal number of in-the-money and out-of-the-money strikes.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a neutral tone. In the past six months, the S&P 500 was up 0% while the VIX (13.03) down by 4%.
Wishing you much success,
Alan and the BCI team
Premium Members,
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 07/27/18.
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 link to the BCI YouTube Channel is:
http://www.youtube.com/user/BlueCollarInvestor
Since we are in Earnings Season, be sure to read Alan’s article,”Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/
Best,
Barry and The BCI Team
[email protected]
I am writing cover call and wondering which stock should I pick from the premium report. Do you mind to help?
Darren
Darren,
To assist our premium members in how to use our member reports, I produced a video for the stock report and one for the ETF report. The screenshot below shows the location of these videos on the member site. let me know if you need additional clarification.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Thanks for the reply Alan,
I have go through the video twice but still find a little bit confused about the cover call strategy.
My main question is which stock should I choose. In my mind, I am thinking to hold a share and write as many call option as possible – is this possible to happen or it is better for me to change the underlying stock according to the report? I do not intend to hold the stock for capital growth as I don’t have deep understanding about America’s market.
Thank you so much Alan
Darren
Darren,
I never hold a stock more than 2 months due to the rule of avoiding earnings reports which come up quarterly here in the US. Using exchange-traded funds (ETFs) will circumvent this issue (see our mid-week ETF reports). Once a trade is entered, the stock isn’t sold simply because it is no longer on our running list but at the end of a contract, we use the most recent report to enter new trades. It is critical to know and understand how to implement our exit strategy arsenal and that will assist us in mitigating losses and enhancing gains. Take your time learning the 3 required skills (stock selection, option selection and position management) and then you will be able to trade in most market conditions even the recent roller-coaster rides we have experienced lately.
When initiating new positions, consider the stocks in the “white cells” of our premium reports.
Alan
My charts get the prices updated at end of each day, and I am wondering if this is alright as it does mean that my decisions on Expiry day are from the ‘Thursdays close’ prices? Or do I need to have live constantly updated charting data instead?(I wouldn’t have thought it mattered as we are not day traders)?
Thanks,
Adrian
Adrian,
I agree with your assessment. Using charts from Thursday’s close along with current option chain information on expiration Friday will more than suffice for our expiration Friday decisions.
Alan
I just started as a premium member about a week ago. I placed several paper trades, ITM, OTM and also a couple of short puts based on the premium report. All for the Aug Expiration.
Question: in general,I recall reading or hearing from some of your material that you should consider stopping the CC position if the price drops 4% below the BE. Is that correct?
Also, if that is true, if you roll down and then the stock price drops down and hits the 4% below BE do you still close the whole position out?
I’m reviewing the material in The Complete Encyclopedia for Covered Calls and I not seeing how to handle this situation. Is there a point at which you close the position out for a loss ?
Thanks Alan
Michael,
For covered call writing, we must first close the short call position before acting on our long stock position. For this, we use the 20%/10% guidelines. If applicable, and the call is bought back, we then decide whether to wait and look for a share rebound, roll down or close the entire position (sell the stock).
The second line of exit strategy decisions is based on the time in the contract, stock performance compared to the overall market, additional news that may impact our bullish assessment and personal risk tolerance.
See pages 256 – 264 in the classic edition of The Complete Encyclopedia and pages 268 – 271 in Volume 2 for detailed examples.
Alan
Hi Alan,
in this article you say :
“Higher implied volatility lowers the probability of an ITM strike expiring in-the-money (Delta decreases)
Higher implied volatility increases the probability of an OTM strike expiring in-the-money (Delta increases)”
OK, understood.
My question is : How high are the chances for the market maker to get his money back, plus some gain, when he buys my ITM calls.
Real time example:
Yesterday, 07/30/18 I bought 200 NOW shares @180.71, and sold simulteneously 2 NOW 08/17/2018 180.00C for 5.91.
My ROO is almost 3%, which is great. But I wonder about the buyer’s logic ?
Can you explain ?
Roni
Hey Roni,
I look forward to Alan’s thoughts on your question.
Your example got me thinking about what a tough game it is to buy short term options gambling on a directional move. The buyer has to be right almost immediately or he/she is likely to lose most of the time.
I just called up the option you sold yesterday on NOW for $5.91. The mark on it is $4,25 so that buyer is already down $1.66 or 28% on that speculative option buy. Plus he is in the steep part of the Theta curve and NOW is down today when the indexes are up. So his speculation does not look good at this point.
The delta on that option is only .44 so for him to get his money back NOW needs to go back up over $3.50 and do it in a hurry or his hole only gets deeper every day. And the longer he holds that option the more time value bleeds off and the more he is hoping for it to have at least $5.91 of intrinsic value at some point or his chances of getting back to the surface are nil.
You, meanwhile, are down a couple bucks on the stock, your sold option is now OTM and you still have room before your break even point at $174.80 plus you own 200 shares of an asset that does not expire: a common stock.
I think I know whose shoes I would rather be in :)! – Jay
Hi Jay,
I do not know where this trade will end up, but I hope Alan can make it clear for us, so we can make the best decision when such a trade show up in the future.
Many times this kind of situation is making me wonder, and worry about the best decision.
Thanks for your supportive words.
Roni
Thanks Roni,
I would not sweat the NOW trade this early in the game. But watch how fast that call you sold eats itself to death even if the stock goes up a little. – Jay
Jay,
When a trader buys a call option, 2 or 3 barriers must be overcome:
Time value: Share price must move up more than the time value aspect of the premium to make a profit.
Theta: Buying an option is like buying a new car. The moment we pull it out of the dealers parking lot, it starts losing value. Every calendar day that passes, the time value decreases assuming no change in implied volatility.
Dividends: If an ex-dividend date passes prior to contract expiration, the stock value will decline by the dividend amount and option holders are not compensated with the dividend as are share owners assuming no exercise occurs..
Here is a link to an article I published on this topic:
https://www.thebluecollarinvestor.com/naked-options-versus-covered-options-where-should-we-take-a-stand/
Alan
Alan,
Thanks for your always insightful reply.
I am enjoying your and Barry’s new book. Very nicely done! – Jay
Roni,
Very smart of you to consider these trades from both perspectives. it enhances our understanding as to how to best manage our positions.
When we sell our options, it is not necessarily the market-maker who takes the other side of the trade. It could be another retail investor or even a portfolio manager/institutional investor. The Options Clearing Corporation (OCC) matches buyers and sellers of options and if there is no match, the market-maker is required to make the market and take the other side of the trade if a published limit order or market order is placed.
Now, why buy an ITM strike? There are 2 categories of answers…speculators and hedgers.
Speculators may buy ITM call strikes when bullish on the underlying where Delta is higher than ATM and OTM strikes and so increases in share price will result in greater increase in option value. Deep ITM strikes will move almost dollar-for-dollar with share acceleration. It is close to owning the stock from this perspective and that is why we use deep ITM LEAPS with our Poor Man’s Covered Call strategy. If directionally wrong, there is more money at risk due to the intrinsic value of the premium.
Hedgers may buy an ITM call when striving towards a Delta-Neutral portfolio to limit market risk. For example, if short a stock (negative Delta), a long OTM call (Delta-positive) can bring that position closer to Delta Neutral. Here is a link to an article I published that will detail:
https://www.thebluecollarinvestor.com/using-delta-to-determine-the-amount-of-risk-in-our-option-selling-positions/
Investors buy and sell options for various reasons. Our sell-side position for covered calls is considered the conservative approach to option-trading.
Alan
Thank you Alan for the detailed response.
I always stick to the guideline of more than 100 open interest, and resulting low bid/ask spread.
Therefore, as you say, there are all kinds of buyers on the other side of my intended trades, and not only the market maker, and they will have all kinds of reasons for buying my calls at 3% above the underlying share stock’s value.
In this case, may I consider that many knowledgeable people are very bullish on that particular stock ?
And is this an edge for my CC trade resulting successful by expiry?
Roni
Roni,
Certainly speculators who buy ITM call options are bullish on the underlying but hedgers may be simply moving to a more Delta-neutral position. We must also bear in mind that for every buyer of that option, there is a seller. I put the greatest emphasis on fundamental, technical and common sense analysis when selecting underlyings. Put/call ratios may play a secondary role in market analysis.
Alan
Thanks
Hi Alan Can you pls let me know your opinion about FB stock and is it good time to buy and can I buy it through poor man covered call strategy .
Do you have any contact num .Your early attention greatly appreciated .
Tnx
Shantha
Shantha,
FB is a great example as to why we avoid earnings reports…a 20% decline in 1-day resulting from a disappointing report.
According to the BCI methodology, FB is not a current candidate for option-selling as seen in the screenshot below. Notice the complete technical breakdown (red arrows) on significant volume (green circle).
Now, some would say that this creates a buying opportunity for a great company for buy-and-hold portfolios. For those with a long-term bullish assessment of this stock, this may be a consideration.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Premium Members,
The Weekly Report for 07/27/18 has been revised and uploaded to the Premium Member website. Look for the report dated 07/27/18-RevA. The reason for the revision is that we received updated risk/reward data today.
No stocks were changed from “Pass” to “Fail” or from “Fail” to “Pass”.
Best,
Barry and The Blue Collar Investor team
[email protected]
Premium members:
This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.
New members check out the video user guide located above the recent reports.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
NOT A PREMIUM MEMBER? Check out this link:
https://www.thebluecollarinvestor.com/membership.shtml
Alan and the BCI team
When putting on an order to do a MCU you don’t think it would be best to deliver the order as a ‘Market order’, instead of a Limit order, so that the expecting profit would make sense to close this whole position?
Thanks,
Adrian
Adrian,
When implementing the MCU exit strategy, we are committed to closing both the short call and long stock positions. If our broker has a buy/write combination form, that would suffice.
If not, and the bid-ask spread is $0.15 or greater, I prefer limit orders where the “Show or Fill Rule” is leveraged where we have the opportunity for more favorable price executions. Remember not to check the “All or None” box when using this Show or Fill Rule.
Alan
Hello Dr. Ellman,
An update for you…
I switched from TDAmeritrade to Schwab this summer – early July. StreetSmart Edge has proven to be much easier to use than Think or Swim for me at least. In one month with an account just south of $200.000.00 and most of it tied up in other investments at that(!), we are up over 14%.
Your “common sense” leg has proven to be invaluable; watching out for earnings dates – irreplaceable; and getting to know the stocks you are in – wise.
AAPL, WTW, SRPT, MU have been workhorses in this success. Except…AAPL has not been with CCW. I have one $200 strike for October (for premium) that is now ITM, but I let the other 100 shares uncovered. With earnings coming up, I thought it would be better to ride it out – although I did buy an inexpensive Put for some insurance.
I’m learning by doing, but you have given me wonderful tools to use and I am grateful.
Bless you, sir.
Randy
Hey Randy,
I’m glad to see that you are enjoying StreetSmart Edge. When ‘Edge was being developed, I was an external beta tester for Schwab. I also participated in some of Schwab’s pilot programs. So we have a lot of background in the Schwab platform and tools.
On the same side of the coin, the TD platform (Think Or Swim, TOS) has some great backtesting tools as well. You might want to think about keeping a (very) small account at TD so you can have access to TOS.
Best,
Barry
Hey Randy,
Welcome to our group! Alan and Barry have been of tremendous value in my option investing education as well.
In only my opinion and in only my way of doing things – we all have to develop our own approach – I like what you did with APPL covering only half your shares.If I can budget a 200 share position in anything I only cover half at any point in time and let the rest run.-Jay