Part 2 of 10. More ranting and raving about options and then we look at Delta.
The leverage, woo derivatives, complex things, it makes me feel sophisticated, that is what a lot of people think about when they think about options. Most of the people buying and selling options do not have any business doing so period, but that is ok because it is what the sharks feed off of. And lets not forget the brokers with their fee’s. Options are a Zero Sum Game..... Most of the money that is lost goes to a handful of people who’s portfolio’s return would make some successful hedge fund managers jaws drop. And when I say a handful I mean a handful, less than 5% of the people who touch options.
You have people who are like Jim Rogers and only sell options because that is what conventional wisdom says, and a majority that only but. First is first, to sell options you have to have a lot of cash, to donate to a single security, if I was going to do some systematic writing on CSCO or INTC (see my last post) you better have 100k of cash to work with (that is for writing 1 and 2 contracts at a time) to be profitable for a long time and you better be alright with sitting on underwater positions for long stock positions for long periods of time. It takes a certain type of mindset.
Lets take a look at some more complex positions
Assume that I want to short a stock but Don’t want to pay a huge premium or can’t find the stock. I am a bear, buy some puts, umm a little too expensive. There is a way to be synthetically short stock, basically a position that behaves very similar to a short stock position, in P and L terms, but you don’t have to wait for a massive drop in the stock for your put to finally start seeing a profit. This involves both a put and a call. Lets say I am very bearish on bear stearns. But the option premiums are super expensive. The stock is at 80. I don’t want to pay $30 for a 90 put, I have to wait until 60 just to make my money back, forget it. Since I am expecting the stock to go down I could sell a call and buy a put. This is assuming that put and call premiums are within the same range of each other.
A second position that I like to run if there is a lot of premium on something like Apple or Google You short an ATM call and buy 2 deep OTM calls, how far OTM depends on how far I think the stock can run. You are essentially getting a little free leverage. This positions can be run with puts if you are bearish.
Many people here are probably familiar with the concept of “covered Calls.” Something I have yet to understand, here you are selling a call when you own the underlying, hence you are capping your upside while, only cushioning your downside. Covered calls can be pretty useful if you work for somebody like Apple and get their stock a discount, plus there is a huge volatility premium on the OTM calls, even the front months, where writing these call’s basically insures my position 50% to the downside. (Remember historically speaking less than 20% of the time will you get called for your stock). But picking up 5% to barely cushion my downside no thanks.
Now that you have heard some of my ranting and raving how about some options terminology and theory.
If you have ever pulled up and options chain you have probably seen delta. But what is delta. Did you ever notice that the option prices at different strikes don’t always move in line with the underlying. And that options with strikes deep in the money tend to move more in sync with the stock than ATM options and you pay less real premium. Delta is the rate at which an option moves compared to a $1 move in the underlying. The underlying always has a Delta of 1. Since one options contract represents 100 shares lets think of the underlying in blocks of 100 shares to simplify things. And right now lets just deal with calls. Pull up an options chain of Google calls and look at the delta’s you will notice that as they get deeper in the money the larger the delta gets. (Delta is expressed as either a decimal or percent, it varies depending on the broker). At some points the deepest ITM strikes have a delta of 1.
Say an option has a Delta of .45 that means it loses 45 cents for every $1 move in the underlying. Google is at $425 (100 shares cost you $42.4k), the 430 calls are 3 months out and $30 these prices are all theoretical, that means your break even on a long call is $455. at $30 a call contract runs you 3k. So if Google goes to 426 or 424 how much does your option gain or lose in value?
Remember that Delta is the rate at which your option prices changes compared to a $1 move in the underlying. If your 100 shares of stock position goes up a buck easy you make $100. If the stock goes up a buck your option position makes $45 (.45 x 100), now your call is worth $3045. Your option loses $45 for every buck move Google makes downward. It gets tricky because Delta can move. This is called Gamma, the rate of Delta’s change. If you buy and option call or put you are long Gamma if you sell one you are short Gamma. More on Gamma and Theta later.
You have probably heard the term “Delta Neutral”. This is where you are long or short a number of shares depending on the option position to neutralize, of hedge risk. Say I buy an ATM Call with a Delta of .42. I then Short 42 shares of the underlying stock. This would produce a Delta neutral position, but Delta Changes, and you have to be careful to not chase the delta, that is have a bunch of small losses due to being delta neutral too add up and kill your profit.
Anyways more later. I had a Good Week this week lol. [more]
This week was nice. I did very well with my bear stearns options positions.
Hey guys I have been super busy, having just moved from New Hampshire back to Louisville, KY to live with my family for a little while, I havent had much time to spend blogging or doing much with the markets at all but just wanted to let you all know that I have not forgot about my options series.