Malandrino/NajarianWEBINAR: Sector Selection and Trading Strategies 6pm ET CLICK HERE FOR INVITE AND TO REGISTER.
Option traders talk a lot about delta. Delta is one of the risk variables that we use to describe a position - it's as important for describing an options position as hair color or height is for describing a person. The strict definition is that delta measures the rate of change in the price of an option per unit change in the underlying asset. Here are some other ways of thinking about delta:
1. Hedge ratio: delta is the a ratio of underlying contracts to options required to establish a neutral position, e.g. for every five 40-delta calls purchased, two underlying contracts (or 200 shares of stock) should be sold short;
2. Stock exposure: as an equivalent to the underlying, e.g. owning a 40-delta call is equivalent to owning 40 shares of stock;
3. Probability proxy: as the rough probability that an option will expire in the money.
When you're trading options, many times you want to isolate the volatility-related part of a trade and ignore other variables, like price. To get price biases out of the picture, you need to flatten your position delta. I've demonstrated some ways to do that in several volatility arbitrage trades here at OP, usually using shares of the underlying stock.
However, sometimes we do want to keep some delta exposure, and in those cases the next question is which strike prices to choose for the trade. For example, take the iShares MSCI South Korea Index Fund (EWY) position opened earlier this week: the trade was motivated by a historically flat volatility term structure, rather than by a price outlook for the ETF. But the bearish fundamentals and strong short-term price trend mean we don't want to be completely neutral, so instead of trading a simple at the money calendar spread, we bought a long-term call that was two strikes higher than the short-term call we sold. The May 56 call has a delta of 47; the January 2014 58 call has a delta of 45.
So by selling the May 56 strike and buying the January 58 strike, we are effectively short two shares of the underlying (-47 + 45). If you traded ten or fifteen lots of this spread, that's not a lot of directional exposure, but again, the primary purpose of the trade was to express a view about volatility. The modest negative delta exposure just means we don't have to fight the trend while we wait for our view to play out.
OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits.
Jared can be followed on Twitter at twitter.com/CondorOptions.
EXCLUSIVE OFFER: Jim Cramer's Protégé, Dave Peltier, only buys Stocks Under $10 that he thinks could potentially double. See what he's trading today with a 14-day FREE pass.
Select the service that is right for you!COMPARE ALL SERVICES
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.
- Real Money + Doug Kass Plus 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas
Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.
- 100+ monthly options trading ideas
- Actionable options commentary & news
- Real-time trading community
- Options TV