I knew better.
A year or two ago, I wrote an article detailing how traders can be right about direction but still lose money if they chose the wrong option. The point of that article was to choose an option with a delta high enough to benefit from any price movement. Before putting on a recent option trade, I should have reread my own article.
Delta is one of the Greeks of option pricing. It measures how much an option's price can be expected to change for each one-point move in the underlying. For example, if I had a call contract on the XEO with a delta of 0.70, each time the XEO climbed a point, my call option would, in theory, gain 0.70. Of course, other factors influence options pricing and it's rarely that clear-cut, but looking at delta can give traders an idea of how an option's price will be impacted by price movement.
Obviously, if the XEO dropped a point, my call option would be expected to lose about 0.70 in price. It works the opposite way with puts, of course, with a put's price decreasing if the price of the underlying climbs and increasing if it drops. For that reason, a put's delta is negative. That reflects the result when a 1-point rise in the underlying results in a loss of 0.70 for a put with a delta of -0.70. A call's delta is positive.
My choice for day trading was an option with a delta above 0.70. Depending on the nomenclature used, some would consider that a delta of 70, multiplying the 0.7 for one contract by the 100 multiplier for most options. In fact, McMillan in OPTIONS AS A STRATEGIC INVESTMENT advises that you eschew options entirely if you're day trading. Trade the underlying, he advises, where your delta is 1.00. I don't go that far, but the idea is that the shorter term your trade is, the higher the delta should be for most traders and most trades. As with any advice, caveats to that exist, but for most cases, that's the way it works.
Delta can provide a rough estimate of how likely an option is to be in the money at expiration. An option with a delta of 0.70 is considered to have a 70 percent probability of being in the money at expiration. Options that are at the money when purchased typically have deltas near 0.50 or -0.50, depending on whether they're calls or puts. This reflects the 50/50 chance that they'll be in the money at expiration. An out-of-the-money option with a delta of 0.15 has about a 15 percent chance of being in the money at expiration.
That's the background. Here's the story. The VIX was hitting what I thought might be support, which to me meant that options were cheaper than they were going to be in the near future. I'm making concerted efforts this year to vary my delta and vega risks. Since my credit spreads are heavily negative on the vega side, I thought looking for some long option trades might balance those portfolio risks. Most times, a climb in the VIX brings equities lower, so a trader who expected the VIX to climb and wanted a long options trade to take advantage of the plumping up of options' values would be looking for long put trades. I was, but there are some exceptions. My search led me to one the evening of July 8. That evening, while researching, I noticed something on the chart for PFE.
Annotated Monthly Chart of PFE:
Confirmation that big money had been doing some buying would come if the next month's candle was a green one, and by July 8, PFE was climbing well off the June low of $17.12. I know from my limited understanding of volume/price-spread analysis that the best time to buy is actually when there's a retest on low volume, but I was looking for a short-term trade of a week or two, with little money put at risk, since PFE was due to report soon. What I really wanted was a test of my theory that options were cheap, that a long trade would moderate my vega risks and that the volume/price-spread analysis, as I understood it, was still working. This volume/price-spread analysis is usually the basis upon which I place my rare directional options trades, and I like to test it every once in a while. This was intended to be a speculative trade for the speculative part of my portfolio.
So what did I do? Something stupid. My further chart analysis told me that before August expiration was up, PFE was likely to hit $19.50. So, with PFE at $18.12 on 7/09, I bought 10 contracts of an OTM AUG 20 call for $0.17 each, for a total of $185.00 with commissions. My thought process was that if PFE bumped up to $19.50 within a week or two of opex, the OTM call would plump up enough that I would gain, especially if it did so rather quickly. However, I was worried about that possibility of PFE rolling over to retest again, and I didn't want to put more than $200 at risk. I was also managing a lot of trades at the time and knew I'd be juggling more if indices rolled down again, and I wanted something I could just let run.
I didn't write down the delta in my trade records for this speculative trade, but an option pricer calculates that the delta of that trade was probably about 0.15. Although in my own defense, I thought that volatility would also increase heading into earnings, also helping to plump up the costs of the option, how did I think I was going to profit on that?
I was right about direction and somewhat right about timing, too. On August 5, well before option expiration, PFE hit $19.50.
Annotated Daily Chart of PFE:
At 3:44:38 on 8/05/2008, with PFE at $19.70, I sold those 10 PFE AUG 20 calls for $0.14 and was lucky to get that. With commissions, I collected $124.99 and lost $60.01 on the trade. In effect, I paid $60.01 to learn that my guess about PFE's target and the before-opex timing was right, but I was all wrong when I made my choice of the option to trade.
I've written articles about traders who wonder why their options' prices aren't changing when the underlying moves in the direction of their trade. That's almost always because the option had a low delta. I set up a trade that had almost no chance of profiting.
Well, actually it had a chance. A 15 percent chance, according to the delta at the time I entered the trade.
I knew better. Now I hope you do, too.