I give this here as a purely educational response to several trades others have made. It's about the relationship between options and the underlying stock. All I bring to the table is thousands of trades, watching this stock/option relationship and my continuous attempt to connect the dots.
IT'S ALL GREEK TO ME.
Let's first speak of Deltas. The option delta is a way to figure the movement of an option as a percentage of the movement of the stock. Let's say you have a stock at $10. You look at the $10 calls out about a month. They're going for .80 cents. On your screen, if you trade that way, or from your broker, you learn the Delta is 40. This means if the stock goes up $1, the option will go up .40 cents. The stock goes to $11 and the $10 call goes to $1.20.
The Delta is different through time. Every day it's different, showing the deterioration of time, the proximity to the expiration date, as well as the up or down movement of the stock. The Delta is not perfect. It is a rule of thumb, and although close in accuracy it is not penny for penny. Look at the $11 calls. The Delta is 32. Again if the stock goes up $1 the option will go up .32 cents. If the $11 call was .40 cents, it would go to .72 cents. You would have almost a double.
In short, the higher the Delta, the better. If a stock and option have a Delta of 100, it's means a $1 rise in the stock produces a $1 rise in the option. This is not rare, but it is not an everyday occurrence. When the Delta is 100 it is said to be "tick for tick." I used to joke that the only way to get a stock to go tick for tick was to buy the stock. About the only way you will get tick for tick is when the option is deep in the money.
Puts are figured the same, but in reverse. If the stock goes down $1, and the Delta is 40, the put option will go up in value .40 cents.
A FEW POINTS.
1) I like Deltas at 60 or higher. I rarely get them, but I said that I like them. I stand by it.
2) Lately, I've spent extra time trying to explain the Delta on the Dow, or the DIA. I've said that I've noticed that when the Dow (DJIA) goes up 100 points, the Dow option goes up about .50 cents. It has proven out time and time again, though not exactly perfectly. The DIA (Diamonds ETF of the 30 Dow Industrials) trades at 1/100 of the Dow. If the Dow is at 11,900, the DIA stock is going for $119. Now you can relate it to $$$$ as the normal index is points not dollars. So if the $119 call option is going for $2.50 and there is about a month to go to expiration, and the Delta is 40, which Molly tells me it often is, then if the Dow goes up 100 points, the option will go up .40 cents. Your $2, or $2,000 if you purchased 10 contracts, would go up to $2.90, or $2,900. Yes, this can and does often happen in a day.
3) I've said repeatedly that I like to buy slightly out of the money options. If a stock is at $5.80, I'll usually trade the $6 calls, unless it's really close to expiration. However, if the stock is at $5.20, I'll play the $5 calls, either in straight options or in writing covered calls.
4) So, slightly in or slightly out of the money is where I see a bigger bang for the buck is made. For example, Molly recently trades the DIA $122 calls. I was hoping she would have played the $120s. the Dow was at just under 12,000. I do not know what the Delta was of the $122s, I'm going to suggest it was 20, but the Delta on the $120s was 40. The Dow went up nicely for two days---about a hundred points a day, but the options only went up to $1.38, starting at $1.03. She could have gotten out with a $350 profit, but decided to wait another day. The market tanked today, down 380 points, so she's under water. There is still time to be redeemed.
5) Kina on the other hand purchased the $119 calls for $2 and sold them for $2.95, netting $950. This was about the same time as Molly's trade. What's the difference? One, Kina's trade was close to the money---meaning the stock and the strike price were about the same. Molly's trade was out of the money by a lot. So, why the higher strike price? I've done this many times, myself. Simply, they're cheaper. Here's the problem: Stocks climb a wall of worry. Options nearingthe expiration date will lose value fast. Kina's $2 option went up .95 cents. Molly's $1.03 option went up .35 cents. That's still a nice one/two day gain. See #8 below.
6) It's important to check the Delta, and ask yourself this question: Is there enough time for the stock and option to move?
You have to make projections here. Is there a chance that the stock will move up, a lot? Is there time to do so? And how is the whole market doing? You've got to give your options a chance to perform.
7) Use the Delta to find a good stock/option to trade, but don't forget that you can use it later in the trade to help you determine if you should stay in the trade. Say the Delta is 70. That gets you excited. Time goes away. The stock moves up a little, but later the Delta is 20. That means a $1 move in the stock (or any percentage of $1) will get you a very limited move in the option. And time is working against you as you proceed.
8) I see that Molly fit her money to the trade. I hear she had about $1,000 to use. The $120 calls were about $1.80. Because many of us do trades in nice neat 1,000 shares or 10 contract batches, we try to get it at that price---to fit rightly. However, it would have been better to do 6 contracts at $1.80, or $1,080 then 10 contracts on the $122s at $1.03, or $1.030. Don't worry about doing odd numbered trades like this. Brokers receive such trades all the time. See Kina's trade. She got the $119s for $2 and had a nice move. I think these $120 calls would have gone to $2.60, or $1,560 ( 6 X $2.60 = $1,560). That would have been a nice profit of $480. Maybe there's still time for the $122s to work. Let's hope so.
EXIT STRATEGIES.
For years I've taught that one should know the exit before one ever goes in the entrance. Let's explore this with options.
There are four ways to determine an exit point:
1) Set it at a dollar figure, say $2.95. If it hits that or above that (say a gap up) you will sell your position.
2) Set a time. This is where Molly's trade should have ended. It was a one to two day trade. Win, lose or draw, she should have been out Tuesday, even at the very end of the day. There was a forklift for those two days, but who knows about the third day of a nice move? Today, the market corrected big time. Maybe this is the time to get in and make up for the loss on this last trade, but now play the option closer to the stock price---say, the $117s or the $118s.
3) Don't forget to set stop losses on a downward move. Molly could have set a sell order at .50 cents, and been out of the trade with a smaller loss. Also, use alerts to let you know when the option is moving.
4) Set the order to sell the option based on what the stock is going for---this would be an alert, but one in the computer. If the DIA, for example, hit $120.50, then the option would be sold no matter what it's going for. You can project what the movement in the DIA will do, but you can't tell the time left in the option, the implied volatility, and other factors. These factors are all jumbled together.
I surely hopes this helps. It's an ART and a SCIENCE.
Wade
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