Covered call writing and selling cash-secured puts are low-risk option-selling strategies used to generate monthly cash flow. Low-risk does not mean no risk so how can we measure the degree of risk we are undertaking? Let’s first all agree that any strategy that aspires to generate higher than a risk-free return (Treasuries, for example) will incur some degree of risk. Portfolio managers and institutional investors focus in on market risk like a laser and use Delta in many instances to ascertain and manage market risk (also called systematic risk).
These are portfolios consisting of positive and negative Delta positions which balance out to bring the net change to zero. Institutional traders use Delta-neutral positions to eliminate risk from their positions. For example, if 1000 shares of stock are purchased for a positive Delta of +1000, the trader may then purchase 200 put contracts with a delta of -0.5, thereby creating a Delta-neutral position. If share value declines, put value increases.
Delta and option-selling
Both covered call writing and selling cash-secured puts are Delta-positive positions. When we write a covered call we are long the stock (Delta = +1) and short the call option (negative Delta, but less than -1) resulting in a positive overall Delta. When we sell a cash-secured put we are short a negative Delta which results in a positive Delta (remember as a kid…two negatives don’t make a positive? Here is does!).
Delta and Greek calculators
Delta is not a static figure. It changes with the other Greeks (Gamma, Vega, Theta, not so much Rho). To get a precise Delta stat, we must use a Greek calculator to compute current implied volatility based on current option premium. To demonstrate the process, I have selected TAL Education Group (XRS), a stock taken from the Premium Watch List on 2/4/2016. At the time, XRS was trading at $47.95 and the market was bearish so we will explore the in-the-money $45.00 call option (premium $4.30) and the out-of-the-money $45.00 put option (premium $1.23). Both are bearish and defensive option-selling positions that generated more than 2% for a 6-week return with significant downside protection.
Delta calculation for XRS $45.00 call option
We calculated the current implied volatility in the purple field on the bottom right by entering current premium of $4.30 and then entering the 40.45 in the purple field on the left side. The stock price and option strike price were also entered and “calculate” in the middle of the screenshot resulting in a Delta figure of 0.7038 (brown field on right).
Delta calculation for XRS $45.00 put option
The same process calculated a put Delta of -0.2900.
Comparing the put and call Delta positions
Since the positions are both $2.95 away from the strike price and there is not a dividend to skew the premiums, we would expect a similar Delta position…let’s see:
Covered call writing
Long stock (+1) – short call (-0.7038) = +0.2962
Selling cash-secured put
Short put Delta = (-) -0.2900 = +0.2900
As expected, the Delta positions are virtually the same.
The Collar and Delta
If we bought a protective put in association with a covered call (Delta-positive) position (known as the collar strategy), we would be adding in a negative Delta component. This would reduce our market exposure as we move closer to a Delta-neutral position, precisely the reason one would consider buying a protective put
Putting this in perspective/Discussion
When selling options we are in Delta positive positions which means we are exposed to market risk. This is part of any strategy that strives to generate higher than a risk-free return. Most investors have portfolios consisting of stock only (individual or part of a mutual fund or exchange-traded fund). These portfolios have Delta positions of +1 with even greater exposure to market risk. When deciding on the most appropriate investment strategies to place our hard-earned money, we must evaluate the inherent risk of that strategy versus our personal risk-tolerance.
Upcoming live events
September 23, 2016
3 PM – 4 PM
“All Stars of Option Trading”
CBOE (Chicago Board Options Exchange)
Event is sold out
September 29th, 2016
9 PM ET
Blue Hour webinar 2: “Using Put Options to Buy and Sell Stock”
FREE to premium members and available for purchase to general members
Registration links and more information to follow
October 17th, 2016 (originally 10/24)
November 5, 2016
Plainview, New York
Saturday morning 3-hour workshop at the Plainview Holiday Inn. I am the only speaker and plan an information-packed presentation covering 5 actionable ways to make money or buy a stock at a discount using both call and put options. We will also evaluate the stocks you currently own for option-selling.
Save the date: Our next Blue Hour webinar, FREE to all Premium Members, will be broadcast on 9/29/2016 at 9 PM ET. The topic is Using Put Options to Buy and Sell Stock. This a new presentation which will be presented for the first time on September 29th. Registration will open in a few weeks. You will receive notification.
Why financial education is so important and why we can’t depend solely on the “experts”
From Thursday’s headlines
Global stocks were mixed this week, with markets continuing to focus on central bank policy. Volatility spiked higher this week, with the Chicago Board Options Exchange Volatility Index (VIX) rising to 15.42 from 14.72 a week ago. Crude oil fell to $42.82 per barrel from $46.50. This week’s reports and international news of importance:
- Muted US economic data and a rise in market volatility combined to lower the odds of a move at next week’s Federal Open Market Committee meeting or at the final meeting of the year in December. While there is a meeting in early November, markets widely expect the Fed to refrain from changing policy just days before a presidential election
- Sub-par August retail sales (-0.3%) and a dip in industrial production (-0.4%) were widely viewed as allowing the Fed to hold rates steady in the months ahead despite a mild uptick in consumer prices (0.2%)
- An advance in CPI was led by medical costs and rents
- UK August retail sales dipped 0.2%, as stellar July sales were revised even higher, to 1.9% from 1.4% previously, the biggest gain in 14 months
- UK unemployment rate held steady at 4.9%
- The Bank of England’s Monetary Policy Committee met Thursday and held policy steady, but indicated it could ease again before the end of the year if necessary
- China’s economy is showing signs of modest improvement, recent data show. In August, industrial output advanced 6.3% while retail sales rose 10.6
- The International Energy Agency forecast this week that the surplus in the global oil market will last into late 2017, longer than previously expected
- According to the US Census Bureau, median household incomes rose 5.2% in 2015, the largest annual rise on record. The increase was the first in seven years but remains 1.6% below the 2007 level before the recession and 2.4% below the 1999 peak
- After an underground test of a nuclear warhead late last week, the North Korean government pushed for recognition as a legitimate nuclear weapons state. The US countered the test by sending two B-1B bombers to fly over South Korea in a show of force
- The Swiss National Bank held its policy rate steady at -0.75% at its quarterly rate-setting meeting. The bank said that the negative interest rate and its willingness to intervene in the foreign exchange market are intended to make Swiss franc investments less attractive, easing upward pressure on the currency
- The Japanese press this week reported that the Bank of Japan may explore pushing policy rates deeper into negative territory in a strategy shift
THE WEEK AHEAD
- US housing starts and building permits are reported on Tuesday, September 20th
- The Bank of Japan and the US Federal Reserve hold rate-setting meetings concluding on Wednesday, September 21st
- US existing home sales data are reported on Thursday, September 22nd
- ECB president Mario Draghi speaks on Thursday, September 22nd
- Flash purchasing managers’ indices are released on Friday, September 23rd
For the week, the S&P 500 ticked up by 0.53% for a year-to-date return of +4.66%.
IBD: Uptrend under pressure
GMI: 1/6- Sell signal since market close of September 12, 2016
BCI: Recent market volatility has guided me to a more defensive posture as we enter the October contracts. I will be favoring in-the-money strikes 2-to-1.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US