How volatility kills premium options ? [Archive]

JROCK

09-20-2010, 09:32 AM

There are many factors that go into determining the value of an option -- the price of the stock, the historic impact of volatility (i.e., how the stock typically trades around regular events like earnings announcements), and dividends and interest, if applicable. After all, options are created, and their available strike prices are set, around the current value of the underlying stock.

Although option values don't always trade directly proportionate to the underlying stock, we can use the delta to gauge the options' sensitivity toward movements in the stock. For instance, you might have held a call option at one time or another with a $35 strike price in your portfolio. But then perhaps the stock traded up through that number, but your option didn't follow it toward profitability. And that can be frustrating because you made the right "call," so to speak, yet the profits didn't follow.

Delta refers to the ratio of change between the underlying asset's price in relation to the change in the option's price, which can help to explain why an option makes corresponding moves with the underlying stock or why it might refuse to go along for the ride in lockstep.

One of the benefits of trading options is that you can capture huge swings (in the double- or even triple-digits) on a simple single-digit spike in the underlying security (http://www.rapidstockprofits.net/#). An option's delta aims to approximate how much an option will change in price for every $1 move in the underlying stock.

The deeper in-the-money the option is, the higher the delta and, thus, the more likely the option will move in tandem with the stock. (That is, if the stock jumps $1, the option could also go up $1.)

This ratio of change between the price of the underlying asset and the option is reflected as a percentage, where a delta of 1 for the underlying instrument (i.e., stock, index or Exchange-Traded Fund) equals 100%. In turn, an option's delta can never exceed 100% of the stock's movement and is instead conveyed as a positive (with bullish plays) or negative (in bearish trades) number.

In other words, delta measures how much an option's price will change in tandem with every $1 move in the underlying security. If the stock jumps $1 and an in-the-money call option also goes up $1, that option has a positive 100 delta. But if the option goes up 50 cents against the stock's $1 increase, then the option's delta is a positive 50 (or, they've matched 50% of the underlying's move).

A delta of 50 is typical for an at-the-money option; that is, if you're holding a call at the $100 strike and the stock is trading at $100. Simply put, the option has a 50% chance of going in your favor. Thus, the deeper-in-the-money calls have higher deltas because their chances of finishing profitably are, of course, higher, and lower deltas correspond to an option's chance of being profitable by expiration.

But what if the stock goes down 50 cents? Then the delta on that call option is 50. However, if it's a put option that drops 50 cents with a $1 spike in the stock, it would have a negative 50 delta, as it drops 50 cents for every dollar the stock increases.

Delta is one of many tools that can help option investors gain a statistical advantage over other traders, because it helps us to determine whether we have an under- or overvalued situation or a good risk/reward picture.