How to Execute a Long Call Options Strategy: Part 2

LONG CALL PRACTICAL BASICS #2:

Now we know that you can profit – and lose for that matter – from an option with its intrinsic value. Some investors actually trade options simply using the technique we just discussed. As you progress in your option education, you will come across some terms that may seem a bit foreign. One of those terms may be delta, which is a concept I will introduce to you in this session.

A call option is a derivative, meaning that its value is derived from the price of the stock. Different options have different relationships to the stock. Think of delta as the link between the stock and the option.

The higher the delta, the more solid that link is – almost like a steel bar. The lower the delta, the more that link becomes like a weak rubber band – which, in turn, makes the relationship less dependent on stock movement and more dependent on other factors.

If there is one Greek that you learn, get to know delta, it’s a fairly easy concept to master. Primarily, delta tells us the rate of change in an options value for every $1 move the stock makes. So, if you have a delta of .80 and the option is worth $5.00 with the stock at $50, and the stock moves to $51 this means the value of your option will increase roughly $0.80 cents. Delta is also a good indicator of the ratio of intrinsic to time value. Basically, the higher the delta, the higher the intrinsic-to-time-value ratio. Another way of thinking about this is the higher the delta, the more expensive the option.

An option with a delta of .90 will usually be in the money, meaning that it will have real value (intrinsic value). This option may have a large amount of intrinsic value and a small amount of time value, where an option with a delta of .30 may have zero real (or intrinsic) value and a fair amount of time value. You can learn more details about delta in our other sessions.

As I said earlier, there are several ways to think about buying call options. Some traders buy lower delta options for less money.. While these have less of a chance of being worth anything before expiration, they are attractive because of their price. These out-of-the-money options are cheap and may have a higher percentage return if they are successful because of their relatively low cost (excluding commission). Other traders prefer deep in-the-money options which can be more costly, but tend to mimic the stock more accurately. This does not mean go out and just buy the largest delta possible, when considering an option with more than 30 days until expiration, the higher a delta gets, the more expensive it becomes, for me personally I typically don’t purchase an options with a delta greater than a 0.92 delta because higher deltas can diminish your leverage excessively, this is a personal preference. Certainly an option with a .99 delta will behave much like the stock, but it may cost a bunch relative to the other options. Remember, the name of the game is risk reduction.

Speaking of cost and risk reduction, retail traders are typically attracted to options because of the leverage and limited risk that they may provide (remember buying options has limited risk, selling options may expose you to potentially unlimited risk).

Because of this attraction, investors are sometimes drawn to inexpensive options, because at such a cheap price they can be quite alluring (they can also be dangerous). If you remember the previous section on delta, you know that delta not only tells us the rate of change in an options theoretical value, it also tells us the percentage chance that the option will expire in the money. For example, if you continuously purchase options with a 0.10 delta, you have a roughly 10% chance that option will be worth anything at expiration. What is worse is that some traders feel that since these options are so cheap, they “load the boat” and buy many contracts. Think about it like this, you’re about to place a bet on a horse race, odds are 10 to 1 that the horse will win, and the ticket costs you $1.00. Whether you buy one ticket or 100 tickets, your ODDS of winning remain the same – you only increase your investment. It’s not like a fixed-ticket raffle where the more tickets you buy the better your chances of winning (even though you’re paying for it in that case!). This is the mistake that many new traders – or traders without a plan – make, they take the fixed sum of money they have to invest and think that more options will get them to profitability quicker. This is completely false and we can prove it!