This week we will continue our discussion of the most basic Greek measure – Delta. It really is quite simple, and certainly worth understanding if you ever hope to trade options (which I hope you do, as they really are fun and fascinating).
How Time Affects Delta Values:
Last week we discussed the useful technique of thinking about Delta value as the probability of an option finishing up in the money.
Delta values are different depending on the lifespan of the option, but in opposite ways depending on whether the option is in the money or out of the money. (As soon as I wrote that sentence, I was reminded why most people’s eyes glaze over as soon as they learn the first thing about options, and also why so few people really know anything about options, including most stock brokers.)
If the option is out of the money (for a call option, the stock price is less than the strike price of the option), the greater the lifespan of the option, the higher delta value it will have. That is because there is more time for the stock to move, so the probability of its finishing up in the money is greater.
For example, if you own a call option at the 65 strike while the stock is selling at $60, if there is only a few days of life remaining in the option’s lifespan, it is highly unlikely that the stock will surge at least $5 during that time so that it would end up in the money. The delta value might be only 5 for such an option, meaning that if the stock goes up by $1.00, the option will increase in value by only $.05.
If the option has an entire year before it expires, it is an entirely different matter. Lots of things can happen in a year. The stock may very well go up by $5 over that long period of time. Consequently, the probability is higher and the delta value will be higher – perhaps in the range of 50 – 60.
Just the opposite is true if the option is in the money (for a call option, the stock price is greater than the option strike price). If there is only 3 days until an option expires, and you own a call option with a strike of 60 while the stock is selling at $65, it is highly likely that the stock will finish up in the money (i.e., over $60). So the delta would probably be as high as 99 or even 100. If the stock goes up by $1.00, the option would go up by $.99 or $1.00.
Owning a call option which is well in the money and there is little remaining life to the option is much like owning the stock itself, except you only have to pay a small portion of the stock’s price to own the option.
If there is a year or so remaining in your in-the-money call option, the likelihood of the stock falling by $5 over that time is much greater than it would be if only a few days were involved. If you owned a call option at a strike of 60 while the stock was selling at $65 and there was a full year of remaining life to the option, the delta value would be much lower than 99 – probably in the range of 60 or 70.
You can see a variety of delta values 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 dismal week for the stock market. The Dow lost 6.2% and the S&P lost 7% and both fell to 12-year
lows. Both of the indexes have fallen more than 24% since the beginning of 2009.
Financials continue to lead the charge lower. The uncertainty that remains within the financial sector led to a 19.2% loss for the week. A slew of negative economic reports certainly did not help the bullish cause either. The negative tone began as the opening bell rang on Monday. AIG reported a $61 billion loss for the quarter. It was
the largest quarterly loss reported by a U.S. company since the stock market began. The Treasury Department and Federal Reserve stated Monday that urgent action was needed now to keep AIG in business.
"Given the systemic risk AIG continues to pose and the fragility of markets today, the potential cost to the economy and the taxpayer of government inaction would be extremely high," they said in a joint statement.
Financials remained in focus throughout the week as Wells Fargo and U.S. Bancorp announced that they would cut their dividends by more than 85% in an attempt to save capital. Moreover, GE which cut its dividend last week reported concerns over the health of GE Capital Finance which makes up roughly 83% of GE’s assets. News of the concern sent the stock lower 17% for the week.
On the economic front, it was reported that housing sales were lower 7.7% for the month of February roughly twice as high as economists’ expectations. The Beige Book also reported that the current economic turmoil could last into early 2010. However, as bad as the previous reports had been, neither of them was as highly anticipated as the Labor Department’s employment report due out Friday. It wasn’t pretty. The U.S. lost another 651,000 jobs during the month of February which led to a jump in
the unemployment rate of 8.1%. Read Unemployment By the Numbers.
"The shorts are having a complete field day in this environment," said Kent Engelke, managing director at Capital Securities Management in Glen Allen, Virginia. "Right now you have everybody so fearful, and these shorts are controlling the market.”
On the technical front the market remains in a short-term oversold position which typically means a shortterm reprieve is near. As we all know oversold conditions, while accurate more than not, are not the end all of technical indicators out there.
There are some interesting things going on in the background at the moment. One that has sparked my interest is the increase in Insider purchasing. After being net sellers when the year began we are seeing a noticeable change in sentiment as the insiders are quickly becoming net purchasers. This type of move often precedes an intermediate-term rally in the market. Some of the biggest technical bears swiftly moved to the bullish side last week as most of the charts are pointing towards an intermediate-term move upwards. One thing is certain, I would certainly like to see that type of move come to fruition.
Overbought/Oversold as of March 6, 2009