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What is Delta? This Answer Changed My Trading Life Forever (Part 2)

Tuesday, July 21, 2009 | Chris Rowe

Hello, Tycoons!

Before getting into Part 2 of the three-part series I started last Tuesday, first I want to tell you that my intermediate-term stock market stance has changed from bearish to bullish.  The reasons why can be found at my options trading service The Trend Rider.  

I had been telling you that odds favored another sell-off and that you should reduce bullish exposure, and that the market's true strength will show itself when we see how strong that sell-off is (was).  The market sold off by about 8%, and then reversed higher relatively quickly. 

My internal indicators show that demand has taken control, and since the sell-off was so mild, it seems to me that it's likely the March low was, in fact, the bear-market bottom.  I still need to see a few more things happen to convince me that it was the bottom but, based on the weak sell-off, it's a lot more likely. 

What I AM convinced of, though, is that, in the intermediate-term, demand has taken control, and it's now much-safer to take bullish positions.

Understand that, when odds strongly favor a particular outcome, we have to play those odds.  But when the market reverses against all odds, it's important to not be emotional but, instead, to get back on the bullish bandwagon and start making money. 

And now to show you how to do that most effectively...

Delving Deeper into the Delta

Last week, in an article titled "What is Delta? This Answer Changed My Trading Life Forever (Part 1)," I started to teach you about the importance of understanding “delta” when trading options.  I decided to split the article into three parts for a couple of reasons:

  • To give you time to digest the first part of the article.  If the word “delta” was new to you, or if it’s something that you had minimal knowledge about, then I felt that understanding it is so important that you should have a week-long break between the articles.  This way you've had a chance to review it, digest it, and maybe even observe how a few different option contracts traded with this new understanding.
     
  • I was just sick of typing. (JUST KIDDING!)  No. 1 covers the reason: to give you the time to digest and review this very important information.

One thing that I want to discuss today is the fact that there are so many options available to trade on each individual stock that expire in one particular month that it might be easy to misinterpret what I was saying last week about how to harness the power of delta to choose the best options to trade.

To review, I told you that, by purchasing deep in-the-money options, you give yourself a high delta, resulting in an option that moves up in value more (point-wise) than an option with a low delta as the stock trades deeper and deeper in-the-money.

This is all true.  For example, if XYZ trades at $50, the XYZ April 45 Call option will move up more (point-wise) than an XYZ April 50 Call.
So, the deeper in-the-money you go, the more the movement in the stock’s price will be reflected in the option's price.

Going, Staying In-the-Money


But this works on both sides, which is why you don’t want to go too far in-the-money.

You have to have a balance between buying deep in-the-money calls, and still staying relatively close to the stock price. Why? Because if you buy a call that is too far in-the-money, you cannot only make 98 cents on a 1-point gain in a stock, but you can lose 98 cents on a 1-point loss in the stock.  You want to enjoy the benefit on BOTH sides of the trade.

For example, I had taken some bearish positions recently because just about every sign the market gave us said it was going to trade much lower.  But even if there was a 90% chance of that happening, of course, there would still be a 10% chance of it not happening. 

In other words, it was a good thing we owned the right options.   That is, the options would have gained a lot more if the market moved down as I thought, than they lost when the market went in the other direction (up).

The Way to Turn Your Deltas into Dollars


Now the market has started to move up again, and you're going to start to profit from bullish positions.  So what you want to do is, instead of buying stocks or Exchange-Traded Funds outright, to buy deep-in-the-money call options on the strongest stocks or ETFs.  

You want to position yourself so that if the stock moves up several points, 85%-90% of that gain will reflect in the price of your call option. But if it moves down several points, you only want more like 50% or 60% of the loss reflecting in your option. 

How do we do this?

When I buy a call or a put option to open a trade (which is the most basic form of options trading), I usually buy an option that is anywhere from being two to five series in-the-money. That is, from the current market price of the stock, I will examine the call options that are two to five strikes below the market price, and the puts that are anywhere from two to five strikes above the market price of the stock.

This rule of thumb varies, depending on how high or volatile the stock’s price is, and therefore how much time value the option on the stock has.  Usually the option that I buy will have a delta of about 0.75 to 0.80.

High Delta in Action

For instance:  Let’s say that I want to buy call options on ExxonMobil (XOM)  with the stock trading at $69.  (NOTE: This is not an actual recommendation.)

Keep in mind, an option contract's price has two parts: intrinsic value and extrinsic value ("time value"). 

The amount by which the option is in-the-money (ITM)  is the "intrinsic value," and the "time value" is the remainder.

How do you know the ITM amount?  Well, for example, when the stock is trading at $69, the XOM Jan 60 Call is $9 ITM. ($69 stock price - $60 strike price = $9 intrinsic value.)

So with XOM trading at $69, if I decided to buy the call options that expire in January, the part of the option chain that I would focus on would look something like the first two columns:

EXXONMOBIL TRADING AT $69

Option

Price

(Price - ITM amount = Time Value)

XOM January 55 Call

$14.40

$14.40 - $14 = $0.40 Time Value

XOM January 60 Call

$10.25

$10.25 - $9  = $1.25 Time Value

XOM January 65 Call

$6.80

$6.80 - $4 =  $2.80 Time Value

XOM January 70 Call

$4.10

 $4.10 - 0  =  $4.10 Time Value

XOM January 75 Call

$2.28

$2.28 - 0 =  $2.28 Time Value


Since the stock is trading at $69, and the ITM call options are the ones that have a strike price lower than the stock price, the Jan 65 Calls would be one series in-the-money.  The Jan 60 Calls are two series in-the-money.  The Jan 55 Calls are three series in-the-money, and so on.

SIDE NOTE FOR LATER: The options that are deeper in-the-money have increasingly higher deltas.  When the option is in-the-money (higher delta), it becomes more sensitive to the stock's movement. 

So, as XOM advances, the call options will become more sensitive to the move (and the delta of any of the listed call options will increase).  However, if the stock declines, the call options will become less sensitive (as the delta decreases). 

That's why, although you want to buy ITM call options, you don't want to buy the call options that are too far ITM (where the delta is too high). 

If the stock trades down, you want to retain some value in your option.  You want the "shock absorber" (decreasing delta) that comes into play when the option moves lower (and closer to the strike price).

Since the delta of the call option is moving down as the stock moves lower, that means the stock's decline will have less of an effect on the option, which is good if the stock is losing value.

Buying Time ... Literally

We've talked about stock prices and intrinsic value. But many factors impact an option's price, like time and volatility, which contribute to an option's extrinsic (time) value.

So, when you're buying options, in addition to looking for higher delta, you also want to look for those options that:

a) Have little extrinsic value (aka, time value).

b) Will still give you a decent return.

c) Have an expiration date that is at least three months later than the time you expect to exit the option contract.  (You don't want to own an option contract that expires within three months).  If you find yourself in an option that does expire in 3 months or less, you can always close that position and buy another option with a further-out expiration month.  You will be paying a little extra for more time. 


Why Do We Care About the Amount of Time Value in the Price of the Option?

The less time value that you have in your option, the less money is at risk of disappearing due to "time decay" as the option approaches expiration.

Why is it OK to Have Some Time Value in the Price of the Option?

Using an extreme example:  You can essentially eliminate time value by buying a call option which is SUPER deep ITM like the XOM Jan 20 Call option (which would be 49 points in-the-money).

But you wouldn’t want to do that because, if XOM moved 5 points higher, you would only make about 5 points on your $49 -- less than 10%

I guess you could do that, but it doesn’t excite me to pay a lot for an option for such a small percentage return. 

At the same time, because the stock’s price is so far ITM, the delta will remain high (near 1.00) even if the stock trades lower instead of higher.  And that means your option would decline by the same amount that the stock declines.  So, if the stock drops 5 points, so would your option.

This is a key point that I am trying to make.  I explained in "What is Delta? This Answer Changed My Trading Life Forever (Part 1)" that you actually have less downside by trading options as opposed to stock when you trade with a higher delta.  But it is important to understand that, as your option becomes too deep ITM, the reduction of risk (when compared to stock) lessens. 

How Deep ITM is Too Deep?


I’ll explain:

If you were to buy the XOM Jan 20 Call option (49 points in-the-money) when the stock is trading at $69, and then the stock traded down 20 points, then the call option would ALSO trade down almost 20 points.

The idea is to buy options that are ITM, but still relatively close to the strike price.  Again, I like to buy two to five series ITM. (In XOM's case, the Jan 60 Calls at $10.25 might be a comfortable distance from the stock price of $69.)

Why are the Jan 60 Calls appealing?  These calls are $9 ITM. This means that within the option’s price of $10.25, $9 is intrinsic value (which is not affected by time decay), and the remaining $1.25 is time value or extrinsic value. (Option price of $10.25 - intrinsic value of $9 = time value of $1.25.) 

So, I only have to worry about $1.25 losing value over time.  But if all other factors (such as time before expiration) were to remain the same, and a few days later, the stock trades from $69 down by $8 to around $61 (only 1 point away from the $60 strike price), the option would probably only trade down $5.25 to $5. 

Thus, the call option will have lost less value than the stock did.

The closer that the stock trades DOWN to the option’s strike price, the less the stock’s movement affects the option’s price (aka, premium).

But if the stock moves higher, the delta would be increasing, so the stock’s movement would have an increasing effect on the price of the option.

You want to have a decent amount of time left before expiration for the same basic reason.  Delta increases on ALL options the closer you get to expiration day.  This may sound complicated, but it’s very simple to understand. 

Time value can be a bad thing, but it can also act as a shock absorber (a good thing if your stock trades in the wrong direction) and can work in your favor

What Happens at Expiration?

As you are in the last 90 days before expiration, your option will start to lose the time value at a much faster pace, so you start to lose the benefit of your shock absorber.  This is why you should be sure to have a decent amount of time before expiration.

That's why I said to decide what your time frame for the stock’s move will be, and then add three months to the option’s lifetime.  If I think the stock will make the move I expect within three months, then I buy an option expiring in six months.  (This only refers to the straight buying of calls or puts.)

If there is less than one day left before the option expires, then you can assume that there will be hardly any time value left in the option, right? 

So let’s say we were looking at XOM a few hours before the market closed on expiration day (i.e., no time left) and the stock was trading at $63. 

Since there is almost no time value figured into the call option's price, you can assume that the XOM Jan 62.50 Call option is trading at about 50 cents or 60 cents.  If XOM traded up 1 point from $63 to $64, the option might trade up 1 point as well, from 50 cents to $1.50 or $1.60. 

If XOM traded up 2 points from $63 to $65, then the option, with a few hours left before expiration, might trade from 50 cents to $2.50 or so.

Thus, the option that was only slightly ITM, in this case, had a delta of 1.00.

This is why having a nice time cushion on your side works to your benefit when the stock moves in the wrong direction.

There's More ... and You'll Learn About it Next Week


I told you that this would be Part 2 of a three-part series.  I would be doing you a disservice if I only gave you half of the story. 

Next week, I’m going to review what we discussed in Parts 1 & 2 VERY briefly, and then I will talk about this:

There are several different variables that cause changes in an option's price, including:

  • Stock Price
  • Time Decay
  • Implied Volatility
  • Delta
  • Interest Rates 

In other words, you must understand that these other factors exist

You probably understand time decay.  You hopefully are getting a nice grasp of delta.  You are well on your way to being light-years ahead of an options novice.  This means that you can make money most of the time instead of being part of the myth that “options lose money most of the time.”

Next week, I'm going to give you a special tool so that you can find the delta of an option and that will make it EASY to decide which option to trade.  In Part 1 last week and Part 2 today, I just wanted you to grasp the concept and the importance of the delta. 

When we conclude this series next week, I'll show you an easy way to chose the exact option to trade with a tool we will offer you for FREE! 

I enjoy your comments and questions, so feel free to click the link below.  See ya next week.
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Chris Rowe
Chief Investment Officer
Technical Analysis Millionaire
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