Delta Can Still be Your Friend

Testimonials

Posted on Thursday, March 30, 2017 at 12:32 PM

As I have said many times in the past, delta is probably the first greek option traders learn after mastering the basics of call and puts. Of course as an option trader advances, he or she also learns the importance of theta, gamma and vega. When an option trader gets to the level of understanding the other greeks, sometimes the importance of delta and direction is forgotten. Let’s take a look at a trade idea we initially talked about a couple of weeks ago in Group Coaching. The trade was meant to profit from theta but delta did the heavy lifting.

When the SPDR S&P 500 ETF (SPY) was trading in the $237 to $238 area a couple of weeks ago, a trader asked me if I knew of a low risk with a potential high reward strategy that he could implement if he thought the market was going to drop at some point over the next month. So in class, we took a look at a long directional put butterfly. Before we go further, let’s take a look at a directional butterfly spread.

The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are considered to be the wings and the short options are the body of the butterfly.

What some option traders don’t realize is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money and using wide strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the size of the wings. In this case, the forecast was for a move lower so a long put butterfly makes sense.

Of course, theta is crucial to make this trade work. If the stock closes at (where max profit is earned) or close to the short strikes at expiration, theta (which is highest ATM) increases the spreads premium up until expiration. But what many option traders neglect when it comes to directional butterflies is the possibility of profiting from delta. When a butterfly is configured OTM, there will generally be a delta greater or less than zero.

We talked about implementing a long 225/230/235 (long the 225, short 2 230’s and long the 235 puts) put butterfly for April monthly expiration. The $230 area was chosen as the body of the butterfly because it acted as previous resistance (target). The cost of the spread and the total risk was 0.50 (or $50 in real terms) which means the max profit would be $450 (5 – 0.50) X 100 if the ETF closed right at $230 at expiration.

The original delta of the spread was -0.11 which means for every dollar the SPY dropped, the spread should increase by 0.11 ($11) based on the delta alone. At the time theta was essentially zero. This past Monday, the SPY dropped over $4 from when the trade was initiated and was trading at $233.75 close to the end of the day. The bid price on the spread increased to 0.95. That means the spread could have been sold for a 0.45 (0.95 – 0.50) profit or $45 in real terms with still 26 days until expiration. In fact, since the drop, the negative delta increased to -0.16 because of gamma. The profit was made almost entirely from a correct move lower and a negative delta as theta was barely positive (just over a penny) and contributed next to nothing to the profit.

Theta is a huge component when profits and a long butterfly are discussed. That there is no doubt. A big advantage of a directional butterfly spread is that it can be a relatively low risk and have a potential high reward depending on how the spread is designed. And as we have seen, an OTM butterfly gives an option trader an opportunity to profit because of delta based on a correct directional forecast even if theta has not joined the profit party as of yet because of too much time left until expiration.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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