We all know options are derivatives, and their prices are derived from the underlying stock, index, or ETF. But with other factors at work – implied volatility, time decay, etc. – how can you know how much an option is going to move with respect to said underlying? Very simple – check out its delta.
Delta is arguably the most heavily watched Greek, as it offers a quick-and-dirty way of telling us what to expect from our option positions as we watch the price action of the underlying. Calls have positive deltas, as they typically move higher on a rise in the stock, and puts have negative deltas, as they typically move lower when the stock rises.
While some investors view delta as the percentage chance an option has of expiring in-the-money, it is really more of a way to project expected appreciation or depreciation. A delta of 50 for a call suggests the option should move 50 cents higher when the stock jumps a dollar, and lose 50 cents for every dollar loss in the stock.
But delta is only foolproof when all other factors hold static, which is rarely the case (and certainly never the case for time decay). If an option is moving more (or less) than its delta would suggest, it is likely because other variables are shifting. For example, buying demand might be pushing implied volatility higher, raising the price of the options. Still, this king of all Greeks is a good starting point for gauging how your options are likely to move.
Options offer a number of unique advantages to the trader, but perhaps the single most attractive characteristic is the ability to control risk precisely and to do so with surgical precision. Much of this advantage derives from the ability to control positions equivalent to stock with far less capital commitment.
However, a less frequently discussed aspect of risk control is the ability to mitigate risk by the judicious use of time stops as well as the more familiar price stops more generally known to traders. Because time stops take advantage of the time decay of extrinsic premium to help control risk, it is important to recognize that this time decay is not linear.
As a direct result, it is not intuitively apparent the time course that the decay curve will follow. A corollary of this is that option modeling software is essential to plan the trade and decide the appropriate date at which to place a time stop.
As a simple example, consider the case of a short position in AAPL established by buying in-the-money November 390 puts. A trader could establish a position consisting of 10 long contracts with a position delta of -608 for approximately $11,300 as I write this.
At the time of this writing, the stock is trading around $384.50; these puts are therefore $5.50 in-the-money. Let’s assume a trader analyzes the trade with an at-expiration P&(L) diagram and wants to exit the trade as a stop loss if AAPL is at or above $387 at expiration. The options expiration risk is $8,300 or more. However, if the trader takes the position that the expected/feared move will occur quickly—long before expiration—he could implement a time stop as well.
Using a stop to close the position if the stock gets to $387 at a point in time around halfway to expiration would reduce the risk significantly. Because the option would still have some time value, the trader could sell the option for a loss prior to expiration, therefore retaining some time value and fetch a higher price. In this event, closing prior to expiration helps the trader lose less when the stop executes, especially if there is a fair amount of time until expiration and time decay hasn’t wreaked too much havoc.
Options offer a variety of ways to control risk. Learn and use all risk control maneuvers available; life is a risky business.
Over half of 2011 has been characterized by a low implied volatility (IV) environment in virtually all underlying securities. This milieu ended suddenly and abruptly on the recent sell-off that started towards the end of July and IV generally remains significantly elevated above its recent nadir due mostly to the European debt and banking crisis.
An example of the recent rise in IV can be seen in Apple ( AAPL ). This underlying spent most of 2011 with options trading at IV’s of 30 percent or below. Since August, the options have begun trading in the range of an IV of 30 percent and higher–even as high as 52 percent. Since its peak in October, IV has steadily declined to its current level of 32 percent at the time of this writing.
In October at the height of IV, traders need to be on guard and conscious of the fact that volatility could decline and possibly their long option premiums. It is important to recognize that positions characterized by being long volatility (positive vega trades), especially long calls, will likely be negatively impacted by increasing prices since IV is generally inversely related to price.
Option strategists wanting to take a bullish position in AAPL may want to consider trade structures which offset much, if not all of the impact of decreasing IV. In optionspeak, this can be described as reducing the vega of the position. Such strategies could include buying a debit call spread as opposed to a single-legged long call position. This technique is referred to as volatility hedging. More on this in future blog posts.