By Guy Bower of www.guybower.com*
OK, hands up, anyone here who has ever bought an option, then seen the market move in your favor but watched the option premium not move along with it. Come on: Be honest.
There are generally a number of reasons why this happens. The reason a trader might make this mistake is because he or she operates under the belief that he or she is trading the market, not the option. One of the messages all of my articles have in common is that an option has its own characteristics, and you should know them before you trade.
The reasons for the option premium not behaving the same as the market can all be answered by the “Greeks”, as they are called. The delta, the gamma, the theta (and those other little ones) are all measures that show how an option can change, given certain other changes (changes in time, the market and so forth).
Now, in the last three articles, we have talked about the delta -- the rate of change in the option price relative to a change in the underlying market itself. We have talked about put and call deltas and total position deltas. (See Table 1 for a review of what we covered.)
For those who aren’t mathematically inclined, it would be easy to see this topic as a little dry, but not understanding your delta is like not knowing the difference between a put and a call. You need to know it.
So, in this article, we will look deeper into the delta, so to speak, and explore the concept of delta over time. It’s a pretty relevant subject to any options trader. You see, a delta of an option or multiple option position does not stay the same over time even if the market holds steady.
This is one of the things that many will call time decay (or “theta” in Greek), but this is a mistake. Time has an impact on the premium level, but it also affects delta. What does this mean? It simply means that your option position’s sensitivity to changes in the market will change -- solely due to the passing of time.
Interesting stuff. This adds another consideration to option trade selection when the trade is based on a forecast of the underlying market.
So, what effect does time have on an option? For single option positions, it’s pretty easy. As the option moves closer to expiration:
- An in-the-money option will move closer to 100% (-100% for puts)
- An at-the-money option will move closer to 50% (-50% for puts)
- An out-the-the-money option will move closer to zero
Likewise with an in-the-money option. As the expiry date draws closer, it is more and more likely that that option will expire in-the-money, and, therefore, the premium will start moving with intrinsic value only. That, again, is your delta. It is moving closer to 100% for calls (-100% for puts).
At-the-money options are the only ones that do not change a great deal over time. An at-the-money call delta is always just above 50% (-50% for puts). It is slightly higher for a longer-dated option than a shorter-dated one, but the difference is negligible.
Real Numbers
So, how does this look in real life? How much of an effect does the passing of time have? Should we really care?
Well, I can answer the last question first: Yes. Table 2 shows delta values for NAB over various strike prices and over a range of time periods. This is assuming a constant share price of $32.00 and constant volatility of 27.5% (around current option vol. levels)
The at-the-money option does not change very much. It falls from 54% with 200 days to run down to 50.3% with one day to run. No big deal there.
The in-the-money deltas show more movement. Take the $30 call. It is $2.00 in-the-money. Just look at how it changes over time. From 66% to 100% over the 200-day period, an increase of 50%.
This means you will generally get more bang for your buck in shorter-dated options. So, in a short-term directional, stick to short-term options. By the way, it also means there is more potential risk because the market could go against you.
The out-of-the-money option delta is just as dramatic. The $34 call, for example, goes from 42.3% down to zero, losing most of its value nearer to expiry.
This suggests that longer-dated options will be more influenced by a move in the share price than the shorter ones.
Multiple Option Positions
A few paragraphs ago, I mentioned that single options positions are easy to analyze. Well, multiple positions are too. Because we already know how to determine a position delta (just add up the individual deltas), the rest is pretty straightforward. (See Table 3.)
For example, consider a bull call spread. Without the market moving, the net delta of the position will increase over time as the distant (sold) strike delta falls faster than the closer (bought) strike.
Say we have a long $32.00 call and a short $34.00 call with 200 days to run. The position delta is 22.3% (54 - 31.7). As time passes, this delta increases. With one day to go, we have a delta of 50.3% (50.3 - 0). So the bought or closer to the money holds on to its value more than the sold or distant strike.
What if the bull call spread was in-the-money? Say we bought the $28.00 and sold the $30.00 calls. With 200 days of time, we start out at 11.3% (77.6 - 66.3) and end up moving toward zero as both deltas move toward 100%. This implies that there is little point in holding an in-the-money spread with little time to run.
Play around with different combinations of options in Table 2, and you will start to get a feel for how the delta will change over time. Overall, knowing how these positions will behave in real time is something you need to know before you trade.
*Reprinted (and modified) with permission from Guy Bower of www.guybower.com
