One of the more fun things about the six months or so of posting for OptionProfits is comments and notes I get. Many center on the same type of questions, namely not understanding how the trade is "working." Understanding how a trade will work, prior to placing the order, is one of the most critical components of success. Mark Sebastian and I touched on this in the "Not All Deltas Are Created Equal" webinar and I am going to go further today.

Aqumin Delta AAPL Chart For Reference

Delta is a fundamental component of (part of, anyhow) how options work.

For Review (please see the above mentioned webinar): Every option has a delta and it is a derived value to show the change in the price of the option for a $1.00 move in the underlying. For most options the value of the delta is 0 to 100. As an example, a 50 delta option (the at-the-money call) will move up $0.50 with a positive $1.00 move in the underlying.

A long delta position wants the underlying to move up.

A short delta position wants the underlying to move down.

Delta is sensitive to a change in volatility. As volatility and time to expiration increases, deltas tend to 50. Long options rise in value when the implied volatility increases.

What I want to do is tie the risk to the delta type. This is not a complete list but merely a primer for the kinds of thinking you need to do prior to initiating a trade. You should be comfortable with this type of analysis prior to any trade you make.

For the examples below, I am going to stick to long delta positions only (the reasons I will explain at the end).

High delta positions (70 deltas and over)

For the high delta position, the underlying does not have to move too much in your direction to be profitable, but you do incur substantial premium risk. On the flip side, there is very low or no exposure to a change in volatility.

Long deep in-the-money calls and call spreads- These trades are better for stocks where the options are buying leverage and saving the cost of actually purchasing the underlying. You risk the premium or the value of the spread.

Risk reversal (long call, short put for different strikes) and at-the-money combinations (long call, short put for the same same strike)- These trades are better for slower moving (lower historical volatilities) names (think a sleepy technology stock like a Microsoft (MSFT)) since the short put creates a larger potential risk (you can lose more money than you put up). This would be a case where you want the leverage. For these trades, there should be little cash outlay or even credits up front (of course you still need the margin). Avoid these trades for more risky, high volatility names.

Mid delta positions (40 to 60 deltas)

For the mid delta position, the underlying has to move in your direction solidly and the premiums at risk are generally much lower. These positions are more sensitive to a change in volatility.

Long at-the-money calls and call spreads- These trades are better for stocks that are more volatile where you expect the implied volatilities to stay constant. The call spread helps to reduce volatility risk substantially.

Short at-the-money put spreads- These trades are better for more volatile stocks where you expect the implied volatility to decline.

Low delta positions (5 to 35 deltas)

For the low delta positions, the underlying has to move substantially in your direction but the premiums at risk are very low (the short put has substantial risk but receives a credit to start). These positions are sensitive to a change in volatility.

Long out-of-the-money calls- These trades are better for stocks that have higher historical volatilities where you expect the implied volatility to remain constant. A drop in implied volatility can wipe out the move in the delta.

Short out-of-the-money puts- These trades are for stocks that will stay flat or rise. There is substantial risk in a short put in that it is possible the seller will be put the stock. The seller of this put is expecting the volatility to decline.

Long call butterfly (long the tails, short the wings) - These trades are meant for stocks that will rise slowly. The buyer of this butterfly is expecting a moderate decline in implied volatility.

This is by no means a complete summary of deltas and positions, but I want to get across the idea of fitting the position to the trading idea and understanding the risks surrounding the trade. For homework, work out the short side of the same trades to cement the concepts. I can review the short side in my next Big Idea.

At the time of publication, Andrew Giovinazzi held no positions in the stocks or issues mentioned.

Andrew is the Executive Vice President of Business Development for Aqumin, where he participated in the design team to apply AlphaVision to the financial markets. For 15 years he was a member of the Pacific Exchange and the Chicago Board Options Exchange, where he actively made markets and traded in both equity and index options. At the same time Andrew started and ran the Designated Primary Market Marker post for Group One, Ltd. on the floor of the CBOE where it became one of the highest grossing posts for the company in 1992 and 1993. While in Chicago and San Francisco, Andrew was instrumental in creating and managing a training program that allowed Group One, Ltd. to dramatically increase its trader count over an eight year period. He left Group One, Ltd. to co-found Henry Capital Management in 2001.

OptionsProfits For actionable options trade ideas from a team of experts, visit TheStreet's OptionsProfits now.
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