This week we will start a discussion about the "Greeks" - the measures designed to predict how option prices will change when underlying stock prices change or time elapses. It is important to have a basic understanding of some of these measures before embarking on trading options.
I hope you enjoy this short discussion.
A Useful Way to Think About Delta:
The first "Greek" that most people learn about when they get involved in options is Delta. This important measure tells us how much the price of the option will change if the underlying stock or ETF changes by $1.00.
If you own a call option that carries a delta of 50, that means that if the stock goes up by $1.00, your option will increase in value by $.50 (if the stock falls by $1.00, your option will fall by a little less than $.50).
The useful way to think about delta is to consider it the probability of that option finishing up (on expiration day) in the money. If you own a call option at a strike price of 60 and the underlying stock is selling at $60, you have an at-the-money option, and the delta will likely be about 50. In other words, the market is saying that your option has a 50-50 chance of expiring in the money (i.e., the stock is above $60 so your option would have some intrinsic value).
If your option were at the 55 strike, it would have a much higher delta value because the likelihood of it's finishing up in the money (i.e., higher than $45) would be much higher. The stock could fall by $4.90 or go up by any amount and it would end up being in the money, so the delta value would be quite high.
On the other hand, if your call option were at the 65 strike while the stock was selling at $60, it would carry a much lower delta because there would be a much lower likelihood of the stock going up $5 so that your option would expire in the money.
Of course, the amount of remaining life also has an effect on the delta value of an option. We will talk about that phenomenon next week.
You can see the delta value of every option we are long or short in 8 actual option portfolios conducted at Terry's Tips and learn all about the wonderful world of options by subscribing here. Why wait any longer to make this important investment in yourself?
I look forward to having you on board, and to prospering with you.
Terry
It was another atrocious week for the market and the end to another grim month for Wall Street. The S&P 500 hit a 12-year low and the Dow closed at lows not seen since 1997. February marked the fifth losing month out of the last six in the S&P 500 and the largest decline since last October.
On Monday it was reported that the U.S. government might convert its preferred shares in Citigroup to common shares. The news helped to alleviate bank nationalization fears that had plagued the market the prior week. The bounce quickly faded as the session wore on and ended lower for the day.
On Tuesday the market bounced higher off of short-term oversold levels despite poor economic news out of the housing sector. The S&P/CaseShiller House Price Index reported a year-over-year decline of 18.6%, larger than economists' expectations of -18.3%.
The day also witnessed Ben Bernanke's Semiannual Monetary Policy Report before Congress. Bernanke stated that there was "considerable economic uncertainty", but the recession could potentially be over by the end of 2009 and the economy could recover during 2010.
More disappointing housing data was reported on Wednesday as Existing Home Sales declined 5.3% in January. The decline led to the lowest annualized rate since 1997.
On Friday the government officially took a 36% stake in Citigroup.
"There are continued beliefs that Citibank is not the last bank that the government will take a large stake in," said William Lefkowitz, options strategist at brokerage firm vFinance Investments in New York.
"Some people believe that if the government takes a 30 to 40 percent stake, which they did in Citibank, that would be considered some form of nationalization," he said.
GDP was also announced on Friday and the report was not good. One month ago it was estimated that the fourth quarter would show a 3.8% decline. Well, that wasn't even close. The Commerce Department revised the decline to 6.2%. It was the largest revision since the government started keeping records back in 1976.
"Consumers are just hunkering down and saying 'game over,' and businesses in response are cutting back on investment and employment," said Brian Bethune, economist at IHS Global Insight. "It's a negative feedback loop."
"I don't think there is the confidence that the recovery is going to happen very quickly. It's going to take time," said Scott Fullman, director of derivatives investment strategy for WJB Capital Group in New York.
As for the technical picture, the gap down on Friday and the current short-term oversold extreme in the major indexes should lead to a short-term bounce as we enter the early sessions of next week. Of course, there are no certainties in trading, but the probability of a short-term bounce looks very good. As for the sustainability of the bounce, well, I am not certain if anyone knows that answer.
Overbought/Oversold as of February 27, 2009
Major Benchmarks