Below is a slide with data from 2006 but still relevant for illustration. Assuming during the summer or so of 2006 you see the following stock quotes and related Deep ITM calls going out 1 - 2 years. Now you can buy 100 shares each of EBAY, SBUX and MMM for a total of almost $16k or you can buy deep ITM Leaps and spend about $6,550. These LEAPS have deltas ranging from .93 to 1.00 so on the whole,the option portfolio has a high sensitivity to the movements of the underlying stocks but at almost 1/3 the cost and thus less risk. This is pretty basic but understanding deltas we can see how we can use options to replicate long stock portfolios for long periods of time with much less risk. Thus you can do many more things with your cash and be more flexible. You can invest the $6,550 in 3 LEAPS and put the remaining $9k or so in fixed income (i know rates suck now but they were much higher in 2006) and preserve most of your capital. You can turn the 3 stocks into better dividend stocks perhaps by putting that cash somewhere that pays interest or dividends. You could also use the remaining $9k to buy more LEAPS DITM to diversify in more than 3 stocks, perhaps 6 - 10 and better manage your portfolio. The lower risk of using DITM options and taking advantage of DELTA means you give yourself more choices and we use LEAPS to get more time. We can get same rewards with less risk (almost same rewards as average delta is not exactly 1.00). To prove how this works in both good and bad times, I updated the two portfolios months later in SEP 2006 and here are the results: Looking at these pics you can see all 3 stocks did poorly over the summer of 2006. The stock portfolio lost $2,484 and the LEAP portfolio lost $2,430. Almost identical as a result of the deltas (the difference being the fact that it is not 1:1 perfectly). So both lost the same dollar values. The percent losses make it look so drastic but you cannot be fooled by that. The stock portfolio required 3x the risk or so as the LEAP portfolio. So the numbers show you can get the same performance using DITM LEAPs as proxies for the stocks with less total capital at risk and the final results should be almost the same.
Thanks for the explanation. On the Puts side, delta for deeper ITM approaching -1, and deeper OTM approaching zero? delta (+/-) 0.5 ATM (Call/Puts). The negative sign on the Puts side is throwing me off a little.
(cont...) So using the most sensitive options and using time on our side with LEAPS we can see how options can be used as proxies for long stock positions. Some will say you can achieve the same by using a LONG CALL/SHORT PUT combo as a synthetic future on the stock which is true. There is margin for this though even if margin is lower than buying the stock outright. I think most beginners would prefer holding LEAPs long than engaging in a margined trade but just be aware that a synthetic future in the stock can also be used. But anyway this is just a demonstration of using the higher sensitivity to your advantage. ITM costs more but you balance that with higher leverage/sensitivity. Next we look at ITM spreads to counter the examples of understanding of ITM calls. Everything here is the same for puts just flipped so I wont repeat it.
+/- always throws people off. Think of it this way. For calls, delta tells you how much the call goes up if stock goes up. For puts, delta tells you how much the put goes up when the stock goes down. Forget the signs for now.
Thanks for the illustration. Question: The $20 strike with delta .92 - is saying there is a 92% probably that the stock will trade ITM by expiration (2008)? How much can we rely on this probability, since the market changes all the time and the delta changes with it? and there is a 2 year gap between 2006-2008?
Well not exactly. The .92 delta is also an approximation of the probability that the strike will be ITM AT expiration. The stock could move in and out of the money before expiration but it is an AT EXPIRATION probability. As for reliability, you nailed the problem. Delta changes daily due to gamma. Therefore I use it as a quick probability proxy at the time I open a position but do not expect that to hold as the stock moves. But as the delta moves the prob changes as well and you adjust your expectations along with it. I use it only for a snapshot at the time I am looking to open a position. It is not a primary tool or crutch but a good quick guide to confirm or clarify understanding. ITM options are pricey because the probabilities are high. OTM options are cheap and not as sensitive (Delta/Gamma) because the probabilities are low. THis is a perfect illustration of the risk/reward trade-offs factoring in probabilities though very basic.
Got it, thanks! Now I understand why selling OTM Puts is better because of the low delta and time decay both work in your favor.
Don't mean to get too ahead of myself here, however, the SPX has been going down since 2007 and the economy is getting worse.... seems Bear Call spread would be a better strategy to use than Bull Put spread for the current financial climate?
I will be back on later to pick up the pace, I just wanted to lay some groundwork, the rest of the material will go much quicker. The delta discussion was just to get some beginners thinking about delta in the bigger picture. I will finish with some thoughts later tonight and then tomorrow we will discuss theta and next week vega (I will be ouf of the country most of the week so will do my best to keep up). Also, not sure why this thread is being rated, I am not doing this for ratings or for the general public, only people who are interested, the rest can ignore it as not useful for them.
Thanks Coach, appreciate your time! I am doing a lot of reading on my own and started my 1st papertrade with TOS and download TOS desktop (played around with the application, like the analysis tool). I have also been analyzing the trades from thread SPX Credit Spread on this forum, learning a lot..... I still don't know how you pick strike prices, but not worrying about it right now, just learning and trying to understand what I can absorb at the moment. Have a wonderful trip!