Barry on Trading Options: All About Delta

Posted By Tate Dwinnell |  Subscribe in a reader | Comment 1

Below, new SelfInvestors.com contributor Barry shares some more thoughts on trading options.  For more about Barry, please see his first introductory post.  Thank again Barry, another great post!

2DIME’S INVESTOR NOTES

Monday, October 29th, 2007 www.SelfInvestors.com

 

“DELTA is not an airline or a place in Louisiana.
 
Another week is off to a good start. We finally had some rain here in North Carolina after too many days without a trace. With every drop that fell, I kept thinking about a better place for it and the California fires kept coming to mind. I reconciled that thought with another: that we should always be thankful for what we have and compassionate with those who don’t have as much.
 
Here at home, the week was one of adjusting the items in my trading cart. I normally ask the 30 to 40 equities in my cart to provide me with a weekly paycheck. I took some items out and put others in about 14 moves in all, two stock and 12 option trades.
 
I would never recommend a set way to trade. It’s really up to the individual to develop his or her own successful technique. My personal portfolio is about 25% equity and 75% option contracts at any given time. About one third of my option plays are for the current month the rest being at least three months out or LEAPS (Long-term Equity AnticiPation Securities) of six months or more.
 
My current month option trades come from a number of different sources. One is from Selfinvestors.com. Whenever a Breakout is reported by Tate Dwinnell, I read the email and check the stock to see if the stock is a likely candidate. These short term trades are valuable in that they are normally placed on issues with modest volatility and almost no time value factored into their price. The beauty of this is that when the underlying stock moves, the value of the option moves in lock step.
 
I am not going to go any deeper into option trading fundamentals at this time because the above probably sounds like Greek to you equity traders. A pun is intended because “Greeks” are important to understand when trading options. As a matter of fact, when ever I began explaining options, one of the first things I discuss is not what an option is or how it differs from a share of stock but rather the importance of “Delta.” And I don’t mean an airline or a place in Louisiana. DELTA takes you right to the heart of an options trade. So why not go there first.
 
Before placing an option trade I always make a physical note of the options symbol, theoretical value, open interest and DELTA. My technique is to jot down a short two or three line entry in my Day-Timer/Journal. I do this as a way to cross check myself to make sure I am sticking to my personal parameters. I don’t pay much attention to historical or implied volatility because my analysis of the underlying stock both fundamentally and technically tends nicely to that. In short, if I don’t really like the prospects for a near-term move in the stock, I don’t play the option. Sites like Selfinvestors.com make my life easy. If there is good volume pushing a breakout move and there is positive institutional interest in the stock, I’m in.
 
 
The Delta of an option is a key in determining the productivity of the trade. Delta is simply a ratio, or number, that tells you how many dollars an option will move for every dollar move in its’ underlying stock. Focusing on the desired Delta eliminates the concern over whether the option is “in-the-money” (Has equity value) Has equity value)or “out-of-the-money” (Has no equity value, i.e.; all fluff…Time value and implied volatility)
 
Options hatch from stocks. They are derivatives in that they derive their value from the stock they represent. An option contract gives you the option to buy (call) or sell (put) 100 shares of a stock at a locked in price (the strike price). Some people call it a “right” for a predetermined number of days to buy or sell 100 shares of a stock at a given price. Well, that’s exactly what it is…but, it’s only an option, it is a non-material thing. No votes for the board of directors, no growth diluting dividends and no pretty certificates of ownership to hang on your wall or ferret away in your safety deposit box. One cool thing though….. If the stock splits, so does the option.
 
Back to Delta. If a stock is selling for $48, and an option to buy 100 shares of that stock (called a CALL) is purchased for $8 and that CALL has a Delta equal to 1.0, if the stock moves $2 to $50, the CALL will move 1 to 1 with it and have a new value of $10. If the CALL has a Delta equal to .50, when the stock moves $2 to $50, the CALL will move $.50 for every $1 and have a new value of $9. It’s a percentage move of the stocks move.
 
Got it? If you take a serious look at the choice to buy $48 shares of stock vs. $8 options, it says a lot about the relative value of trading options vs. shares of stock. It reveals the increased “LEVERAGE “involved when using options. Understanding DELTA is also key to understanding the different nature of the risk in an options investment vs. that in an equal dollar investment in shares of stock. That’s a subject for a later date. If you are going to make a living trading, I think you have to understand both stocks and options.
 
Let me add that Delta works the same way with PUTs. When I first started trading options, the concept of a CALL came pretty easy. PUTs took a while. I don’t know why because they are a mirror image of a CALL that can be used to make or save money off of a downtrend. Don’t worry if you are in the same boat; because increased age, with its increased dyslexia seems to help.
 
That’s enough for now. Plenty of food for thought. Whenever I feel I am running low on trading ideas or know how, I pull out and read the following quote from one of my all time favorite books, “The Power of Your Subconscious Mind” by Joseph Murphy. A copy of this book has a permanent place in my blue room and is always within reach at critical moments in my life. I first read it about 15 years ago. I have recently dusted it off and am on my third re-read. Scary stuff!
 
The True source of wealth
Your subconscious mind is never short of ideas. There are within it an infinite number of ideas ready to flow into your conscious mind and appear as cash in your pocket in countless ways. This process will continue to go on in your mind regardless of whether the stock market goes up or down, or whether the pound sterling or dollar drops in value. Your wealth is never truly dependent on bonds, stocks, or money in the bank; these are only symbols — necessary and useful, of course, but only symbols.
 
The point I want to emphasize is that if you convince your subconscious mind that wealth is yours and that it is always circulating in your life, you will always and inevitably have it, regardless of the form it takes.” Joseph Murphy
 
It’s what’s inside that counts.
Cheers, 2Dimes / Barry Brush (email me at support@selfinvestors.com I look forward to your comments.)

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