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Weigh Your Options

Author: James Brumley (info)
Website: http://bluegrassportfolio.com
Posted: December 15th, 2006 at 3:47 pm EST
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Some of you will already understand today’s concepts, while others may not. In either case, it’s a lesson worth learning for the first time, or again. For those of you who don’t trade options, don’t quit reading just yet - we’ll be wiping away some of the mystery behind option pricing.

As a basic review, an option is simply the right to buy or sell 100 shares of a stock at a predetermined price, within a predetermined amount of time. Of course, if you want to have this right, you must pay for it. This is what investors do when they buy an option - they pay someone else for the right to buy or sell a stock before the option expires. Obviously anyone who buys an option is reasonably confident that the stock will change price as they predicted. If they are correct in their prediction, the option they purchased will increase in value, and they can sell it for a profit (or they can choose to exercise the option). Conversely, the person who sold the option to the buyer thinks the stock will not move as the buyer predicted by the time the option expires. (For additional details on the ‘how’ and ‘why’ of options, check out this link:
http://www.bigtrends.com/document.jsp?documentid=915.)

For example, suppose XYZ company shares are currently trading at $35. If I buy a January 35 call option on XYZ company at a price (or ‘premium’) of $5.00, I am buying the right to buy 100 XYZ shares at $35 per share by January’s expiration day. For this right, I am paying $500 (100 shares x $5.00 premium = $500 ). Obviously I feel that XYZ shares will be at least $5 higher than the current price by the time the call option expires, since I was willing to pay $5 more (per share) than their current value for the option. But I only have a few days to turn a profit before the option expires, so the clock is ticking on my prediction. Suppose that between the day I purchase the call option and the day the option expires, the stock moves from $35 to $45, for a $10 gain. Since I own the right to buy XYZ shares at 35 per share, and shares are at $45 before the option expired, how much is my call option worth? Let’s see. If I can buy 100 shares at $35, and sell those 100 shares at $45, I can make a profit of $10 on each of those 100 shares. That makes my call option worth $1000 (100 shares x $10 premium = $1000). Since I originally paid $500 for the option, my net profit of $500 gives me a gain of 100%.

Unfortunately, option pricing in the real world is not nearly as black and white, nor is it that simple. Most option traders know that just because a stock changes price by a certain dollar amount, it doesn’t mean that the option does too. The difference between the dollar change in the stock and the dollar change in the option price is known as ‘delta’ (one of the ‘greeks’ in option trading). For example, if the delta for an option is 50, this means if the share price of the stock goes up by $1.00, then the premium (or price) of the option will only go up $0.50. Why is knowing the delta of any particular option important? It allows you to set accurate, yet reasonable, price targets for your option trading.

As always, a real-life example will best illustrate this point. Take the Nasdaq 100 Trust (QQQQ) for instance. Yesterday the QQQQ’s closed at 44.39. One of the closest ‘in the money’ options for the QQQQ’s is the January 43 call, which last traded at a premium of $1.85. The delta for this option is 77.9 meaning for every $1 the QQQQ’s move, the option premium will theoretically change by $0.779. If the QQQQ’s move higher by $1, then the option premium will move to a theoretical $2.65 (options only trade in nickel or dime increments) for a gain of 43%, or about 80 cents. But what if the QQQQ’s lose $1.00? Then you will have lost about $0.80 of your $1.85 premium, or about 43%. Not an enviable outcome, but not as bad as losing a whole $1 on your $1.85 investment.

On the other hand, the January 45 QQQQ call (not actually ‘in the money’) last traded at $0.55, and its delta is 43.5. If the QQQQ’s move up $1.00, then the option price increases only by 43.5 cents. That $1 gain would only get the call to about $1.00, but for a nice 81% gain. Should the QQQQ’s fall by $1, then the option price falls to $0.10, for a 81% loss. That’s not necessarily good news either, but the upside potential is also much higher than with the January 43 calls.

So now that you know, the question is, are you trying to squeeze blood from a turnip? In other words, are you setting price targets on your option trades that are completely unachievable? If you’re thinking the QQQQ’s are only going to move by $3, then your targeted price change for your QQQQ options need to be appropriately less than $1. In fact, the less ‘in the money’ the option is (like a strike price of 44), the lower your expected dollar change target needs to be. Of course, on a percentage basis, you get more bang for your buck that way…..but with additional risk. If your option is really deep in the money (like a strike price of 40), you may find that your delta is almost 100. Risk is minimized, but so is the potential percentage gain.

So what determines delta? Primarily the time left until expiration, and how deeply in the money the option is. In other words, how risky an option is will determine the delta value. But the delta calculation isn’t even the critical point of today’s TrendWatch. The goal today is simply to point out that not all options are created equal, and that you must weigh the risk and reward potential of each one. And more than that, knowing delta data allows you to set reasonable price targets based on what the underlying stock is likely to do. The delta analysis is a logical, organized way to add some precision to your option trading.

For a detailed look at delta analysis and other option pricing models, I recommend Leonard Yates’ High High Performance Options Trading, and Sheldon Natenberg’s Option Volatility & Pricing. We’ll also be looking at another important option pricing aspect in a futureTrendWatch - time decay.

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