Out of the money option trading
Periodically I use this column to answer questions sent by readers. As a bullish position, can you compare the advantages and disadvantages of buying one contract of an in-the-money Call option with a Delta of 70, vs buying two out-of-the-money contracts with a Delta of 35 each also a Delta of 70 total? This is a sophisticated question. To answer it, we have to explain that Delta is the percentage of the next one-point price movement of the stock that will be experienced by the option.
So the value of a call option with a Delta of 70 would rise by 70 cents, if the underlying stock went up by one dollar. Are these positions equivalent? The answer is that they are equivalent only for the next one-dollar move in the stock, and only if that one-dollar move happens today, with no change in market expectations. In other words, no they are not. On that day, a partial option chain for the March options looked like this:.
The Bid and Ask prices for the strike calls, with a delta of. The gold highlight at the strike shows the dividing line between calls that were in the money like this one, and calls that were out of the money. The Bid and Ask prices for the strike calls, meanwhile, with a delta of. This is so that we can compare different scenarios. In that case, the break-even price on the calls would be so high that it would be nearly impossible to make money on them, and that possibility would probably be dismissed.
But if each position is only held during the time in its life when its time value is not deteriorating too rapidly, as shown here, then a different picture emerges. The two delta calls make more, or lose less, at any SPY price level, than the single delta call, assuming no change in Implied Volatility; except where SPY is unchanged a month from now.
So far, a definite win for the delta calls. One potential disadvantage of the delta calls is that they have a higher Vega value, meaning that they will suffer more in case Implied Volatility drops. This would hurt the delta calls more. Close enough to be called a tie. Along with the somewhat higher Vega exposure, the two delta calls also have higher negative Theta, meaning that after this first 30 days, they would suffer more from time decay.
Since we would have no intention of holding them longer than 30 days, time decay after that would not matter to us, so we can disregard this. In the end, it turns out that there are definite advantages to using the two out-of-the money options, as long as we do not hold them after 30 days. Most comparisons are equal or better than the one delta call, and the cost is considerably less. The key is that we must not hold them close to their expiration date, where Theta would overtake their advantages.
Being able to compare different positions requires good software tools, as well as the ability to interpret the information they provide. The software is available from multiple sources — these graphs happen to be from Tradestation, and others exist. For the skill to interpret them, call your nearest center and ask about our Professional Options Trader class. For comments or questions on this article, contact us at help tradingacademy.
Disclaimer This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter.
Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.