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Know Your Delta When Hedging With Options

Understanding it is important if you want to get the best results.

Steve,

I enjoy your columns and I learn a lot from them, but this one ... about hedging through the summer left me with more questions than answers. ... Two in particular are how can I apply this to individual stocks, and are there any other ways such as covered calls that make sense for weathering through the summer months? I appreciate all your good work and thanks for your time. -- RJ

The reader refers to my recent column

on using options to protect or hedge equity positions through the summer as an alternative to the "sell in May" bromide offered by brokers and talking heads.

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As I've often said, one of the best things about options as an investment tool is their dynamic quality, which allows for the customization of positions that align with your outlook and goals. This column's main objectives are to educate readers about options' general applications and to identify specific opportunities that I believe present a good risk/reward profile.

Whether you're speculating, hedging or adjusting an existing position,

options delta is probably the most necessary tool in establishing a position that will produce the best results for you. Delta measures the expected change in an option's value for a unit change in the price of the underlying security.

Last week I provided suggestions on how to hedge a position or portfolio and used the broad example of what it would take for 1,000 shares of the

Nasdaq 100 Trust

(QQQ) - Get Report

to be fully protected for beyond a 10% price decline through September. One suggestion was to buy 20 of the September 33 puts, which would provide a delta of -1 once the QQQ drops 10%, meaning even if the QQQ dropped to zero the loss is limited to the purchase price of the puts. The drawback is that this hedge cost $1,500, or 4% of the value of the existing QQQ holding.

But let's look at selling calls (or overwrite) to gain protection for the same 1,000-share QQQ position. For starters, if you want to be fully hedged and not incur any loss if the QQQ drops to zero, it would require selling some $36,000 worth of call premium. With the QQQ recently trading at $36 Friday, it would require selling 240 September 37 calls at $1.50 per contract. Your downside is now completely protected. Your upside potential is $37,000, or a 102% gain, if the QQQ settles at $37 on the September expiration. The potential loss is unlimited, of course. For example, if the QQQ rises 10% to $40, the loss would be $32,000.

A more practical example of writing calls against stock would be when you're looking for protection of a certain percentage decline. For example, assume you own 1,000 shares of XYZ Corp., currently trading at $50. If you want to establish a hedged or delta-neutral position at the current price, it would require selling about 18 September 50 calls (assuming 35% implied volatility), or approximately 50 of the September 60 calls to achieve an options position with -1 delta in relation to the current XYZ holding. But remember, as XYZ's price declines, so does the delta of your call protection.

A better way to look at call-selling is to apply the concept of a stock going to zero to a more realistic scenario. This might include making the assessment that you want protection only for a 10% decline in XYZ shares. Use the above information to decide how many calls would need to be sold to achieve that downside protection. Remember, you will be balancing between using much lower risk/reward of fewer closer in-the-money calls against selling a larger number of calls that are further out of the money and therefore may allow for more upside gain.

For a more detailed explanation on how to calculate and gauge the expected changes of an options position's delta as related to dynamic hedging, please look at this

column.

Northernmost Trading Post

Hi Steve, I know this one was written back in Oct. 24, 2003, but hey, I am way up north in the Yukon Territory.In the article " Never Rich Enough" you made the comment: The lack of perceived premium has more to do with the fact that the puts have moved into the money than to any change in volatility or time remaining. As options move further into the money, their price increasingly is comprised of intrinsic value. On the other hand, out-of-the-money options have no intrinsic value, so their price is comprised entirely of time premium and implied volatility. I am wondering if option traders can use that to their advantage and buy options that are slightly in the money ... with the idea that the "reverse" of what you say is true. If so, the underlying security could move further against you, and the intrinsic value might convert over to extrinsic value. ... Is that correct? The reason I am wondering is because it appears you could structure a trade more weighted in your favor. As in, the underlying security has to move further against you in proportion to your loss than it does in proportion to your gain. Am I correct in my reasoning? Thanks in advance for your answer. Jeff Wagner
Whitehorse, Yukon Territory

Jeff, my last and only encounter with anything related to the Yukon involved a bottle with the last name of Jack. The result was a body-surfing incident 21 years ago from which I'm still shaking out the cobwebs. So I understand the delay in the delivery of your question.

Jeff's head, on the other hand, seems pretty clear about options' price behavior. Let's quickly review some of the concepts, their implications and possible applications. The two main drivers of an option's value are the price of the underlying security and implied volatility.

Let's focus on the price of the underlying security. As Jeff says, an in-the-money (ITM) option has intrinsic value equal to how far the strike is ITM. For example, if XYZ Corp. is trading at $60 per share, its 50 call will have an intrinsic value of 10 per contract. Depending on the amount of time remaining and the implied volatility, the call option may be awarded some additional price premium above its intrinsic value.

An out-of-the-money option's (OTM) value is composed solely of its time and implied volatility, with a little prevailing interest rate calculation thrown in. Therefore, it is without any intrinsic value and can be considered an essentially worthless asset. While most of its value is drawn time remaining, that clock also can cause the largest impairment to value in the form of time decay that accelerates as expiration approaches, as represented by the slope of theta.

All of this leads back to the concept of an option's delta, or how much you can expect the price of a given option to move for one unit change in price of the underlying security. So yes, as an option moves further out of the money, the rate of change in its value decreases relative to the price of the underlying stock.

But do not mistake this transference of value from mostly intrinsic to one based on time and implied volatility for some sort of gain. The option you own is declining in price, albeit at an increasingly slower rate. If the option ultimately expires worthless, that will completely sever any price relationship between the option and the underlying stock.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.