By: Steve Smith
Today, I wanted to dive in to some reader mail. We begin with a message I received from Brian, a member of the Options360 community. It reads…
I had been “taught” that if you wanted to be straight bullish or bearish a stock and use options for leverage then deep in the money was the way to go since the delta was near 100. You seem to vastly prefer slightly out of the money strikes for your straight plays. Can you talk about the logic behind this? Also, is this a long-term preference or is it somehow linked to current market conditions? – Brian C.
This is a great question and hits on some of the variables that go into choosing a strike or a strategy. The main inputs for deciding what approach to take is price and time. That is, what size or percentage move do you expect in the underlying stock and in what time frame do you expect that to happen…
Options are leveraged products (stemming from low-margin requirement to control 100 shares per contract). However, this leverage can cut both ways, delivering big profits along with bone-crushing losses.
One of the keys to having the “right” kind of leverage becomes a function of delta and gamma. Let’s look at delta today and we can address gamma in another article.
Delta is the expected change in an option’s price for every $1 move in the price of the underlying stock. Delta can range from 0.00 to 1.00, with calls being expressed as a positive number and puts as a negative number. The rule of thumb is that an at-the-money option has a delta of 0.50.
It is very important to understand that delta is not fixed. It is a function of the underlying stock price and the time remaining until expiration. As an option moves further into the money and time decays, the delta increases at an accelerated rate.
For example, with Apple (AAPL) trading at around $156.5, the November $150 call has a delta of 0.55. The Nov $170 Call, on the other hand, has a delta of 0.27.
If AAPL moves up to $170, the 150 call would have a delta of 0.91 while the delta on the 170 call would leap to 0.50. As you can see an approximately $20 move, or 13%, would have a larger impact in percentage terms on delta of the further out-of-the-money call.
Conversely, as an option moves further out of the money and has more time remaining, delta decreases at a slower rate.
This is a valuable feature of options in that your profits will accelerate as price moves in your direction and losses will decelerate relative to the stock as price moves against you – so profits can pile up faster than losses.
To get to the heart of the question of “what I use,” it really depends on the situation and my expectations. Since I’m mostly a short-term trader with established entry, target, and stop losses, I try to find the balance that will provide enough time for the thesis to play out as well as a decent bang for my buck.
If I want to make a strong directional bet, this typically means buying an option one strike at the money with about 30 days until expiration. This provides sufficient time so theta (time decay) doesn’t come into play. It also offers enough time to leg into a spread.
That said, most of my trades are initiated as spreads, my basic structure is buy a 60-70 delta option and sell an option with a 30 delta. Diagonal spreads, both bullish and bearish, are my “go to” strategy as they combine directional or capital appreciation with income collection through time decay.
Obviously, there are a host of variations; while I would almost never make an outright purchase of a call that is deep in the money, I sometimes buy a spread in which the long portion is in the money to give the spread some intrinsic value.
One thing I never do is buy options that are more than 15% out of the money, as these “lottery tickets” rarely pay off as time decay becomes a real drag.
The bottom line is always define your expectations and find a strategy that aligns with it.
We go over these concepts and more we go over throughout your membership to Options360.
If you have a question about options trading, remember, you can ask me directly once you join, so don’t wait! Let’s address whatever problems, questions, or concerns you may have…
Don’t miss it… or the next trade.
Looking forward to trading with you!
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.