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Wednesday, September 20, 2017

Is There an Effective Delta?

We talk about option delta very frequently in this blog and in my Group Coaching class and although the concept may be well-known to many of you by now, it still bears revisiting time and time again because of its importance. I would venture to say that once an option trader learns what a call and put is and what their rights and obligations are, the next thing they learn is delta. Of course, as you move through your option trading career and learn more nuances and specifics about options, you discover there are more option greeks than just delta to comprehend. That being said, I find delta to be still one of the most important concepts to understand particularly for my style of trading.

Option Delta

As a quick reminder for those who are well-versed and also for those that may be newer to options, let’s take a quick look at delta before going any further. Delta is the rate of change of the price of the option relative to the change in the underlying. Keeping it simple, for every dollar the stock moves higher or lower, the option premium should change by that amount. Delta values range from 0 to 1 and can be positive or negative depending on if it is a call or put and whether the trader is long or short the position. As a quick example, if an option trader purchased a call option for 3.00 with a delta of 0.60 (long calls have positive deltas) and the stock moved $1 higher, the new value of the option would be 3.60 (3 + 0.60) due to an increase from the positive delta which correlated with the positive $1 move higher. Delta works the same for spreads but there is an element that many option traders may never think about that may actually change the way they think about delta as far as spreads go.

An Example

Let’s look at a vertical debit spread and examine what the “real” and what the so-called “effective” delta is on the spread. Let’s say an option trader had a bullish bias on Valero Energy Corp. (VLO). With the stock trading just under $67 and an expected move higher in about a week, the trader can purchase a January expiration bull call spread with just over a week to go until expiration. The trader buys the January 65/67 call spread for a price of 1.30. This means the maximum risk is the amount that was paid and would be lost if the call options expire worthless at $65 or below at expiration. Maximum profit is the difference in the strikes minus the cost of the trade or 0.70 (2 – 1.30) in this case.

The long 65 call has a positive delta of 0.72 and the short 67 call has a negative delta of 0.44. Adding those together, an option trader would say the current delta on the spread is positive 0.28 delta which means if VLO rose $1, the spread should increase in value $0.28 ($28 in real terms) with all other variables being held constant. Consider taking a look at this from another perspective. The maximum profit on the spread is 0.70. With the stock trading at $66.65 at the time, the stock would need to move just $0.35 higher and of course stay there at expiration for maximum profit to be realized. This means a positive $0.35 move higher at expiration would net a profit of $0.70. If you divide 0.35 into 0.70 you get 2 which could be argued that the spread’s “effective” or theoretical delta is 2 because if the stock moves $0.35 higher, it equates to a $0.70 increase in premium and profit at expiration. You probably never looked at it in that way huh?

Final Thoughts

As we can see and as many of you probably know, option delta can effectively tell an option trader how much the position’s premium will change based on a directional move. When it comes to spreads, there may be more to think about than what the current delta or “real” is. You may want to consider what the “effective” delta is at expiration based on how much a move is needed to achieve maximum profit at expiration.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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Thursday, September 14, 2017

Do Trailing Stops Make Sense for Options?

The market has moved higher, lower and higher again over the last month or so. Even though the market has rallied as of late closing at all-time highs yet again, there's still a potential for the market to move yet lower again. Regardless, whether the market continues to move higher or lower, it is always a good time to talk about stop losses. Traders may hear the terms trailing stop loss and stop loss order and wonder exactly what those terms mean and how a stop loss can potentially enhance a trading strategy. Well, worry no more because that is exactly what we will review in this blog entry. I also find that traders have a difficult time understanding order types. Below we will takea brief look at a couple of ways to use stop losses.

Let's start with the basics which is defining a stop loss order. Basically, a trader will tell the broker a certain price on a stock (or option) where the position will be closed; but it's a little different than a typical closing order. For longs, the closing price is below the current market price and for shorts the stop loss closing order is above the current market. Let's take a look.

Stop Loss Example

A trader could purchase a stock for $20.00 and set a stop-loss order at $18.50. This means that the position will be closed at the market price once the stock drops below $18.50, pretty simple right? It is called a stop loss order because it stops the trader from taking any more losses. Many traders use a set percentage of a trade for a stop loss order. If a trader wants to use a stop loss order for an option, the bid and ask prices would be monitored and then the same decisions as were made in the stock example are followed.

Trailing Stop Loss Example

A trader chooses a lower target price to keep losses in check and tells the broker to sell the contract once this price is violated. There is another stop loss strategy, the trailing stop loss. A trailing stop loss is either a fixed percentage or a fixed nominal increment from the current market price. Once the market price moves away from the stop, the stop moves, or trails, the market. It remains in place, though, if the market moves towards it.

Once the trailing stop loss is triggered the stock is sold, just like the regular stop loss. The benefit of the trailing stop loss is that it is flexible. If you purchase an option for $10 and set a trailing stop of 50 cents, the sell target is $9.50. Of course, as the stock increases in value, the 50-cent trailing stop will do follow (the stock trades at $10.50, the trailing stop becomes $10.00).

A trailing stop loss can be used very effectively in profit taking and it is a strategy I have used often myself. Let's revisit the $10 stock with a 50-cent stop loss. If the company reports blow-out earnings, driving the price sharply higher, it might be time to adjust the trailing stop loss. In this example, let's say the stock jumped to $12.00. A nice profit, but there could be some more room to the upside. Maybe the trader will adjust that trailing stop a little tighter to, say, 25 cents. Doing so allows the trader to lock in a profit of at least 1.75 (12 minus 10 = 2, 2 minus 0.25 = 1.75).

Consider this option so to speak, next time you are in a profitable position which hopefully will be soon!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, August 31, 2017

Employment Report Prep

On the first Friday of each month the government releases data on the employment situation. Of all the monthly reports, job numbers have the most impact on interest rates.  That impact often reverberates in currencies, precious metals and occasionally the equity indexes.

The day ranges for many markets are well above average on Payroll Fridays. This report is frequently responsible for setting an extreme (high or low) for a week or 2. Quite often the high or low for the month is made on the day of this report or shortly thereafter.

The table below shows the average day ranges for interest rate futures and the average range on employment day.

The most scrutinized components of this report are nonfarm payrolls and the unemployment rate. Federal Reserve policy makers pay close attention to these data.  Economists and analysts reveal labor market estimates prior to each release. From these numbers consensus estimates are posted. For Friday’s (9/1) report, nonfarm payrolls are expected to have grown by 180,000 jobs and the unemployment rate consensus is 4.3%. The current prices in treasury futures reflect these expectations. The direction the markets will take tomorrow will be determined by the difference between estimated and actual numbers. Generally, fixed income futures will rise if the data are weaker than expected (lower nonfarm, higher rate) and fall if the numbers are better (higher nonfarm payrolls, lower unemployment rate) than anticipated.

Treasuries tend to gravitate to recent high volume or fair prices in front of a job report. Momentum is movement from a fair price. Most payroll days give us a direction to lean on for a few days and sometimes for weeks to come.

Interest rate futures impact many other markets. Recently the markets that correlate closely to treasuries are gold and the dollar, mainly versus the euro and yen.

In preparation for Friday’s report odds favor a rise in treasuries and precious metals and dollar weakness (euro and yen strength) if the data are much weaker than consensus estimates. On the other hand, if the data are much stronger than expected, treasuries should fall (interest rates rise), gold should weaken and the dollar rally.

Job reports are basically a starting point each month. Momentum often becomes clear and gives us a direction to lean on in not just treasuries, but peripheral markets as well.

John Seguin, Senior Futures Coach

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Thursday, August 24, 2017

Multiply Your Delta

In my Group Coaching class, I often give the traders a quiz with many of the questions pertaining to the option greeks. Despite delta being the most recognizable greek in most cases, option traders still struggle to determine how it truly functions. Even if you think you have a pretty good grasp of delta, I still see option traders not fully understanging how delta can change a positions value when more than one contract is implemented.

Option Delta

Delta is probably the first greek an option trader learns and is focused on. In fact it can be a critical starting point when learning to trade options. Simply said, delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. A positive delta means the position will rise in value if the stock rises and drop in value of the stock declines. A negative delta means the opposite. The value of the position will rise if the stock declines and drop in value if the stock rises in price. Some traders use delta as an estimate of the likelihood of an option expiring in-the-money (ITM). Though this is common practice, it is not a mathematically accurate representation.

The delta of a single call can range anywhere from 0 to 1.00 and the delta of a single put can range from 0 to -1.00. Generally at-the-money (ATM) options have a delta close to 0.50 for a long call and -0.50 for a long put. If a long call has a delta of 0.50 and the underlying stock moves higher by a dollar, the option premium should increase by $0.50. As you might have derived, long calls have a positive delta and long puts have a negative delta. Just the opposite is true with short options—a short call has a negative delta and a short put has a positive delta. The closer the option’s delta is to 1.00 or -1.00 the more it responds closer to the movement of the stock. Stock has a delta of 1.00 for a long position and -1.00 for a short position.

Taking the above paragraph into context, one may be able to derive that the delta of an option depends a great deal on the price of the stock relative to the strike price of the option. All other factors being held constant, when the stock price changes, the delta changes too.

AAPL Example

What many traders fail to understand is that delta is cumulative. A trader can add, subtract and multiply deltas to calculate the delta of the overall position including stock. The overall position delta is a great way to determine the risk/reward of the position. Let’s take a look at a couple of examples.

Let’s say a trader has a bullish outlook on Apple (AAPL) when the stock was trading at $159 and purchases 3 October 160 call options for 6.00 each. Each call contract has a delta of +0.51. The total delta of the position would then be +1.53 (3 X 0.51) and not just 0.51. For every dollar AAPL rises all factors being held constant again, the position should profit $153 (100 X 1 X 1.53). If AAPL falls $2, the position should lose around $306 (100 X -2 X 1.53) based on the delta alone.

Using AAPL once again as the example, lets say a trader decides to purchase a October 160/165 bull call spread instead of the long calls. The delta of the long $160 call is once again 0.51 and the delta of the short $165 call is -0.38. The overall delta of the position is 0.13 (0.51 - 0.38). If AAPL moves higher by $3, the position will now gain $39 (100 X 3 X 0.13) with all factors being held constant again. If AAPL falls a dollar, the position will suffer a $13 (100 X -1 X 0.13) loss based on the delta alone.

Last Thought

Calculating the position delta is critical for understanding the potential risk/reward of a trader’s position and also of his or her total portfolio as well. If a trader’s portfolio delta is large (positive or negative), then the overall market performance will have a strong impact on the traders profit or loss.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, August 17, 2017

Is the Reward Worth the Risk?

When you read the title of this blog, you probably think that is the first thing you should consider before entering a trade. Smart traders should consider this when entering a trade and in my opinion and it should be documented in your trading plan. But for this particular discussion, I would like you to consider is the reward worth the risk after the trade has been implemented and time has passed.

In my Group Coaching class, I always like to tell my traders that you should consider multiple exits for profit and loss. I cannot tell you how much this has improved my option trading. You have to be a risk manager first and then a trader second to be successful on a consistent basis over the long haul. But why do I have and why should you consider multiple exits? The answer to me is simple and it all boils down to removing risk. I see too many traders that hold positions because they expect to earn the maximum profit or close to it. Now don’t get me wrong, there are some positions that exceed our expectations and the maximum profit is earned sooner than was expected. Those profitable trades are not as common as those that take their time becoming profitable or of course end up losing. Let’s go through an example below that may better illustrate my point.

In class this past Tuesday, we discussed buying an Apple Inc. (AAPL) August 157.5/162.5 bull call spread. At the time AAPL was trading in the $160.75 area. The spread at the time was going to cost about 3.00. This is the maximum risk on this position and it would be realized if the stock closed at $157.50 or lower at expiration which was at the end of the week. The maximum profit is the difference between the strikes (162.50 – 157.50) minus the cost of the spread which in this case was 2.00 (5 – 3). That would be earned if AAPL closed at $162.50 or higher at expiration. The spread had a greater risk than reward but it also had a lower break even than a spread that could have been purchased for less. As I always like to say there are many tradeoffs when it comes to option trading.

Later that same day, AAPL moved higher and the spread’s value moved up to 3.70 meaning a 0.70 ($70) profit could have been realized in less than a day. For some option traders, that might not have been a big enough profit to consider selling some of their position (me not being one of them). But now look at the current risk/reward scenario. There is an additional profit of 1.30 (2 – 0.70) that can be realized but the overall risk has not changed. It is still 3.00. Stop losses cannot guarantee anything but it might be a good idea to consider moving a mental or hard stop up to remove some risk.

What if the spread became even more profitable would your thoughts change then? If AAPL continued to move higher throughout the week, the spread’s value might increase to 4.50 which would be a nice profit of 1.50 (4.50 – 3). Now the potential profit left at this point would only be 0.50 but once again the risk remains at 3.00 (max risk). For at least a majority of your contracts, one should ask is it worth the additional gain when so much is still at risk?

I picked a vertical debit spread for this example but what if an out-of-the-money (OTM) vertical credit spread was chosen and the initial reward to risk would have been even worse based on the criteria. A profitable credit spread would make the new reward/risk even more skewed.

Option traders will sometimes only think about the initial reward/risk scenario when entering a trade. If you consider yourself a risk manager, which I believe you should, then the reward/risk should also be considered as the trade is active especially after a profit can be realized.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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Thursday, August 10, 2017

Fundamental Correlation

The title sounds fancy but a good technician uses charts to appreciate the impact of economic or fundamental events. The immediate or knee jerk reaction to economic reports exposes sentiment. There are countless books and articles that preach the so called ‘proper way’ to react to economic reports. Fundamentals or supply and demand principles move markets, of that there is no doubt. It is diversity of expectations that move markets. And such moves reveal momentum and frequently start trends.

In just the week there were 2 incidents that surprised traders in the financial sector. The first was the job openings report, also known as JOLTS. It was reported that job openings had increased far more than expected.  Normally this report has little if any impact on interest rates and stock indexes. That was not the case this past week. Equity indexes spiked higher and treasury futures were hit hard, not because the report showed economic growth, but because the number exceeded expectations by a large margin.

The lesson here is that reports near consensus estimates are already priced in. The degree of difference between expectations and actual results is what makes markets move.

For example, let’s say a report is expected to show improvement in the economy. If the numbers are positive, but not as optimistic as expected, the market will likely fall. Even though the report was bullish, it was not bullish enough.

The S&P chart shows the spike higher early in Tuesday’s session last week. In just 60 minutes the rally spanned the length of an average day range. It was followed by a violent reversal later in the day following more threats and increased tension with North Korea. 

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