Covered call writers and put-sellers know that option value is impacted by the change in stock price by the amount of its Delta. Delta, one of the option Greeks, is defined as the amount an option value will change for every $1.00 change in share value. If a call option priced at $2.00 with a Delta of .50 sees its underlying security rise in value by $1.00, the theoretical value of the option will rise to $2.50, all other factors remaining the same. However, there are times when stock price moves up and option value moves down (and vice-versa) and to explain this we need to explore other factors that influence option pricing.
Let’s look at the other four Greeks and see which is the most likely to result in this unusual inverse relationship between share price and option value for calls:
Gamma is a second generation Delta. It’s always positive and will only result in option value increase as stock price rises…can’t blame Gamma.
Time value erosion is logarithmic in nature (not linear) especially for near-the-money strikes and can certainly negatively impact option value over time. However, what if option value goes down the same day share value rises. When this occurs, we can’t blame Theta.
Interest rates have very little impact on option value especially in low-interest rate environments. When rates are changed, it is usually by 25 basis points and so Rho is considered a secondary Greek, with little influence on our 1-month option-selling decisions. Definitely, can’t blame Rho
By process of elimination, this apparent anomaly must be caused by Vega, the amount an option value will change for every 1% change in implied volatility. A decrease in implied volatility can counterbalance an increase due to Delta as share price rises.
One obvious time of decreasing implied volatility would be before (higher volatility) and after (lower volatility) an earnings report. Nike (NKE) reported earnings after hours on 12/22/2015. Here is the chart for the $130.00 in-the-money call option just prior to market close that day:
Note the following:
- NKE trading at $131.85 (yellow field)
- $130.00 call trading at $5.50 (brown field)
- Delta = .58 (red oval)
- Implied volatility = 33.54% (green oval)
The earnings announcement was initially received positively and here is the screenshot of that same option the next day:
Here we see stock price moved up approximately $1.00 to $132.79 (yellow field) but option value declined to $5.00 (brown field). Factoring in Delta alone, we would expect option value to rise by the previous delta of .58 resulting in a new option value of $6.08 ($5.50 + .58). However, note that the implied volatility (green oval) has declined substantially to 24.43% after the report was made public. Although the Delta component was pushing option value higher, the Vega component not only neutralized Delta but actually caused the option value to deteriorate. As an aside, note that Delta moved up to .65 as the $130.00 strike moved deeper in-the-money.
The Greeks are a mathematical means of calculating the risk inherent in our option positions. Each of the five Greeks are defined based on all others factors remaining constant. In the real world, all other factors are dynamic and so to understand option pricing we must integrate all the Greek factors into the equation. Our goal, as Blue collar Investors, is to become educated to the highest possible levels so our returns can also achieve those heights.
Blue Collar Scholar Competition:
Contest leaders as of Friday’s market close (S&P 500 reading at the end of the year)
Sample Commentary from Michael M:
“Unfounded reaction to Fed decision on interest rate, the “lack” of investing by millennials, a weak energy sector and a still strong dollar will be major contributing factors causing the S&P sliding sideways to December 2015”.
The six winners will be published in the January 10, 2016 newsletter.
Upcoming live appearances
1- Saturday January 23rd, 2016: Kansas City, Missouri
9 AM – 12:30 PM
Matt Ross Community Center
2- New York Stock Traders Expo
February 21st – 23rd
Marriott Marquis Hotel, NYC
This shortened week’s news had a mixed tone to it. This week’s reports:
- The manufacturing sector has had a number of indicators come in softer than expected in recent weeks as the ISM is in contraction territory
- Durable goods orders were unchanged in November, better than the
- 0.6 percent decline that the consensus had expected
- The volatile transportation sector increased 0.4 percent
- Excluding transportation, durable goods orders slipped 0.1 percent, the third decline in the past four months
- Personal income increased 0.3 percent in November, which matched the 0.3 percent gain in inflation-adjusted consumer spending. Steady labor market gains have supported growth in personal income in recent months
- Consumer spending grew at a 3.0 percent annualized rate in the third quarter and was the largest positive contributor to the overall GDP growth rate for the period
- Existing home sales declined by 10.5 percent in November. The primary reason for the soft turnout in November could have been the implementation of a new mortgage disclosure rule, the “Know Before You Owe TILA-RESPA Integrated Disclosure,” that went into effect in October
- On the upside, it appears that the impact was temporary as mortgage applications through the second week of December have risen to the fastest seasonally adjusted rate since 2010
- The latest estimate for third-quarter GDP shows an annualized growth rate of 2.0 percent, down from 2.1 percent previously
- Consumer confidence fell unexpectedly in November, with the index falling 8.7 points and reaching its lowest level since September 2014
- Nonfarm payrolls in November posted a second consecutive strong reading, allaying some fears regarding the labor market
- Despite a decline in November, the ISM non-manufacturing survey remains firmly in expansion territory.
- Strong nonfarm payrolls gains in October and November helped allay concerns regarding the labor market following the slowdown in employment growth earlier this year. This gave the Federal Open Market Committee (FOMC) the confidence it needed to proceed with increasing the fed funds rate for the first time in almost a decade
For the week, the S&P 500 increased by 2.76% for a year to date return of + 0.10%.
IBD: Uptrend under pressure
GMI: 1/6- Sell signal since market close of December 10, 2015
BCI: Cautiously bullish but remaining in a defensive posture selling at least 50% in-the-money strikes and deeper out-of-the-money puts until there is clarity regarding the market reaction to the Fed rate hike.
The BCI team wishes you a happy and healthy holiday season and a lucrative 2016,
Alan ([email protected]) and the BCI team