Option Investor
Trader's Corner

Ozzy Osbourne's Option Advice

HAVING TROUBLE PRINTING?
Printer friendly version

You didn't know that Ozzy Osbourne offered advice on trading options? Perhaps he doesn't. However, the lyrics of one of his songs, "I Don't Know," offers advice that day traders might consider when choosing an option. "You can choose," Osbourne sings, "don't confuse, win or lose, it's up to you." Sometimes the correct choice of an in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM) option for a day trade or any short-term trade determines whether that trade will profit or lose.

A little review might be in order for newbies, but experienced traders can skip this paragraph. A call is in the money when the underlying's price is above the strike price of the call, and a put is in the money when the underlying's price is beneath the strike. For example, if the OEX is at 550, a 545 call is five points in the money and a 555 put is also five points in the money. That five points is intrinsic value. That's part of the option's computed price, but only part. Other factors influencing an option's value include time to expiration and volatility of the underlying, among others. One formula often used for calculating an option's value is the Black-Scholes model. For those who would like to delve deeper into the particulars of options pricing, the www.cboe.com website offers a 25-minute Options Pricing self-paced tutorial on the Online Learning Center portion of the site.

Comparing apples and oranges never works well, so this article on choosing the correct option for a short-term trade focuses on the OEX. In that way, the article doesn't attempt to compare what might happen on an options trade with a volatile GOOG or CME and a complacent-by-comparison index such as the OEX. Generally, the shorter the time period you expect an OEX play to last, the more in-the-money you want your option to be. In other words, if you enter an OEX play in the early afternoon and expect to be out by the close, and anticipate that the OEX will move only two or three points during that time period, you want an ITM option.

Consider a recent OEX move, with a long entry at the close of trading Monday, October 10, when the OEX was at 550.01, and an exit near 9:40 am EST on Tuesday, October 11, when the OEX was between 552.15-552.21. Two call options are detailed, an ITM 545 and an OTM 555 strike. Because the 555's bid/ask spread is tight and the price is above $3.00, a buy at the ask and a sell at the bid are assumed. (Note to newbies: If an option's price is under $3.00, the minimum increments are $0.05, and it's conceivable that you could have split a $0.20 bid/ask spread with the market maker, but since the 555's price was above $3.00, the minimum increment was $0.10, and a market maker wasn't going to split the spread evenly with someone attempting to buy or sell the option, shaving off ten cents of the bid/ask spread. In such a tight spread, you would have had to have paid the ask and sold at the bid.) Because the 545's bid/ask spread is wider, the assumption is made that the buyer paid 70 percent of the spread at the purchase of the option, and collected 30 percent of the spread when the option was sold. That 70/30 spread seems reasonable for many OEX trades, at least in my experience. With those assumptions, the following table depicts the results.

Profit for an ITM and OTM Call:

Why did the ITM option profit more than the OTM one? That has to do with delta, also noted on the chart, both at the time the option was purchased (BTO) and when it was sold (STC). Technical texts define delta as the amount that the option moves for every one-point move in the underlying, the OEX in this case. The deeper ITM the option is, the higher the absolute value of the delta, and the more closely the option's price moves in lockstep with a move in the OEX's.

Call options possess positive deltas, and put options, negative deltas. This reflects the fact that put options' prices move in opposition to the underlying's moves. If the OEX moves up, for example, the price of a put option will move down. For calls, delta ranges between 0.0 and 1.0, and for puts, between 0.0 and -1.0. A call with a delta of 1 would theoretically move up one point for every point the OEX increased, while a put with a delta of -1 would theoretically decrease one point in value for every point the OEX climbed.

In non-technical terms, if you purchase an OTM option with a low delta, the OEX is going to have to move a whole bunch to change the value of that option by a little bit. Sometimes that big move happens, even in the often-range-bound OEX. Big moves were happening then week, for example, when the OEX was cascading lower. More often over the last year, the OEX has tended to move big for a few days and then consolidate in four-to-six-point ranges, sometimes for weeks. Sometimes a four-to-six-point move isn't completed in a single day, so a day trader who never or seldom holds overnight isn't going to capture even that entire four-to-six-point move.

If that's the case, imagine that you're pretty good but not perfect at market-timing and got in rather near the top of a three-point decline and exited fairly near the bottom, all during the same day. If you caught a two-and-a-half-point chunk out of the middle of that range, you'd probably feel pretty good about your timing skills, with a right to that pride. However, capturing that chunk out of the middle might not even capture enough profit in an OTM option with a delta near 0.30 to pay for your portion of the bid/ask spread and commissions. A 2.5-point move in the OEX would theoretically have brought you a 0.75-point move in the put. You might have picked the right time, the right entry and the right exit, and still not have profited, or have barely done so if you were good at splitting the bid/ask spread on both entry and exit and your brokerage charged low commission fees. As of the close on Friday, October 7, with the OEX at 552.93, an October 560 call had a delta of 0.3154, and an October 545 put had a delta of -0.2805. The call was about seven points OTM, and the put, almost eight.

Usually, you don't want to choose an option that much OTM, with a delta that low, if you intend a short-term play. On Friday, October 14, the OEX 565 call had a volume of 3,453, according to one broker. That call had a delta of 0.0494 at the end of the day. In other words, the call was moving up in price about a nickel for every point the OEX climbed. Although the OEX ranged from a low of 545.97 to a high of 550.63, the 565 call ranged only from a low of 0.15 to a high of 0.25. Perhaps these weren't purchased for day trading purposes, but the example demonstrates how difficult if not impossible it would have been to have profited on a short-term trade with an option that much OTM.

Lawrence G. McMillan, more widely quoted than Ozzy Osbourne when considering the choice of a correct option, says in OPTIONS AS A STRATEGIC INVESTMENT, "The shorter-term the strategy, the higher the delta should be of the instrument being used to trade the strategy." He advises that day traders buy near-term options with deltas of 0.90 or above, as those are going to be the options that move most in tandem with moves in the underlying. In fact, McMillan would advise that those day trading equities trade the equity and not the option, since the equity has the biggest delta, a delta of 1.0 or -1.0, depending on whether the stock is bought or shorted. For those day trading indices, however, options provide the needed leverage to be able to participate in movements. In my own day trading of the OEX, I'm more likely to choose an option with a delta of about +/- 0.70-0.80, as that seems to offer the best tradeoff between high deltas and liquidity of the option. At the close on Tuesday, October 4, for example, a trader would have had to choose a put more than 35 points in the money to approach a delta of -0.90, while a put 15 points in the money had a delta of -0.71.

For physics and math types, delta can be found by taking the partial derivative of the Black-Scholes equation for the option price with respect to the stock price. As an option moves more deeply into the money, the pricing curve turns up more sharply, and that tangent line you derived from the partial derivative slopes more strongly. Delta's absolute value increases up to a limit of one.

For the non-math or physics types whose brows are sweating at the thought of trying to take a partial derivative in order to calculate the delta of a particular option, you certainly aren't required to calculate those values or to visualize how that tangent might change as the option pricing curve changes. Many charting or quote services offer information on deltas for specific options. What most traders need to know is that ITM options have deltas with higher absolute values than ATM or OTM options, and the deeper ITM an option is, the higher its delta's absolute value.

Referring back to the chart above, at the time of the purchase of the two options, delta for the call about five points ITM was 0.65. For the call almost five points OTM, it was 0.37. The OEX move was about 2.20 points, so the ITM option should have moved approximately 1.43 points higher (2.20 x 0.65) and the OTM option should have moved about 0.81 points (2.20 x 0.37), a greater difference than that actually seen between the two options. Unfortunately, in this real-life example, it's not possible to isolate changes due to delta alone. The difference between the theoretical movements and the actual movements could be attributed to amateur-hour effects on the exit of the position as well as to other factors.

You math and physics types will have already have glimpsed another truth about delta. Since it's the tangent of a curving line, it will change as the curve does. What that means to the rest of you is that the delta of your option will change as the underlying moves up or down. If you purchase a call and the underlying moves up, the delta of the option will increase, too. That's apparent when studying the chart above. Deltas of both call options rose as the OEX did. In fact, the delta of the OTM option had risen more rapidly, probably also contributing to the narrowing of the differences between the profit on the two options. A more OTM option would not have risen so rapidly.

Generally, most day traders are not going to be calculating subtle changes in delta after an entry and basing exit decisions on those changes. They will be paying more attention to likely support and resistance levels or oscillator evidence. For the everyday trader, most decisions about delta are made at the time of entry. Options pricing changes during a play can be complicated by the peculiarities of puts and calls, the time remaining until expiration, and volatility contraction or expansion. This article was intended to focus on the narrow topic of choosing the correct option for a short-term trade, capturing as near a dollar-for-dollar move in the option and the underlying as is possible. That's not the same thing as getting a bigger return on investment, but the choice is often one that determines whether there's any return on your investment at all.

When making the decision to buy higher delta options, traders must recognize that a move against the position will also result in the price of the option moving down more quickly, so stops must be set and honored. A trader who is swing trading for a number of days and thinks the entry might be a little early and there's a chance of a movement against the position before it becomes profitable might want to choose an option with a slightly lower delta. That's a topic for another article, but I wanted to point out this difference in short-term trades and longer-term trades and reinforce the need to honor stops.

The whole subject might appear complicated, but it boils down to choosing an option that has a delta with an absolute value of 0.70 or above for short-term trades. That's not too complicated for options traders. After all, as Bonnie Raitt might counsel, "We can choose, you know, we ain't no amoeba."
 

Trader's Corner Archives