Option Delta

The delta of an option is the sensitivity of an option price relative to changes in the price of the underlying asset. It tells option traders how fast the price of the option will change as the underlying stock/future moves.

The above graph illustrates the behaviour of both call and put option deltas as they shift from being out-of-the-money (OTM) to at-the-money (ATM) and finally in-the-money (ITM). Note that calls and puts have opposite deltas - call options are positive and put options are negative.

Option delta is represented as the price change given a 1 point move in the underlying asset and is usually displayed as a decimal value. Delta values range between 0 and 1 for call options and -1 to 0 for put options. Note - some traders refer to the delta as a whole number between 0 to 100 for call options and -100 to 0 for put options. However, I will use the decimal version of -1 to 0 (puts) and 0 to 1 (calls) throughout this site.

Call Options

Whenever you are long a call option, your delta will always be a positive number between 0 and 1. When the underlying stock or futures contract increases in price, the value of your call option will also increase by the call options delta value. Conversely, when the underlying market price decreases the value of your call option will also decrease by the amount of the delta.

The above graph shows how the delta of a call option changes as the underlying price changes.

When the call option is deep in-the-money and has a delta of 1, then the call will move point for point in the same direction as movements in the underlying asset.

Put Options

Put options have negative deltas, which will range between -1 and 0. When the underlying market price increases the value of your put option will decreases by the amount of the delta value. Conversely, when the price of the underlying asset decreases, the value of the put option will increase by the amount of the delta value.

The above graph shows how the delta of a put option changes as the underlying price changes. So, when the underlying price rallies, the price of the option will decrease by delta amount and the put delta will also decrease as the option moves further out-of-the-money.

Source : http://www.optiontradingtips.com

Why Trade Options?

Option trading provides many advantages over other investment vehicles. Leverage, limited risk, insurance, profiting in bear markets, each way betting or market going nowhere are only a few. But let's look at a couple:

Leverage

One thing to note before we go on is that the buyer of an options contract pays an amount, known as the premium, to the option seller. An option seller is also known as the writer of the option. The option premium is simply the amount paid for the option - but there is more about this under the Pricing link.

When you buy an option contract from an option seller, you aren't actually buying anything - no asset is actually transferred until the buyer chooses to exercise. It is just an agreement where the buyer has the option to decide if the transfer is to take place. But the option contracts value is determined by the underlying asset - Microsoft Shares as an example.

Options give the buyer the right to buy a number of shares of the underlying instrument from the option seller. The amount of shares (or futures contracts) to buy is determined by;

• The number of option contracts, multiplied by
• The contract multiplier

The contract multiplier (also called contract size) is different for most classes of options and is determined by each exchange. In the US, the contract size for options on shares is 100.

This means that every 1 option contract gives buyer the right to buy 100 shares from the option seller.

So, if you buy 10 IBM option contracts, it means that you have the right to buy 1,000 IBM shares at expiration if the price is right (10 x 100).

Note: In other countries such as Australia, the contract multiplier for stock options is 1,000, which means the every option contract you buy entitles you to 1,000 underlying share contracts. So pay attention to the contract specs before you begin option trading.

This also means that the price of the option is also multiplied by the contract multiplier. For example, say in the above you purchased 10 options contracts that were quoted in the marketplace for 15c, then you would actually pay the seller $150.

This is a crucial concept to understand. If you go out and buy 5 IBM share options for 15c that have a Strike Price of $25, then you will;

• Pay the option seller $75
• If you decide to exercise your right and buy the shares, you will have to buy 500 (5 x 100) (100 being the contract size) shares at the exercise price of $25, which will cost you $12,500.

In this case, your initial investment of $75 has given you $12,500 exposure in the underlying security.

Option trading is very attractive for the small investor as it gives him/her the opportunity to trade a very large exposure whilst only outlaying a small amount of capital.

Say you bought a $25 call option for $1 while the underlying shares were trading at $26. If the market rallies to $27 the option must at least be worth $2 because you can exercise your right at $25. So, even though the shares only went up 3.8% you DOUBLED your money because you can now sell back the option for $2.

Penny stocks are also known to carry this type of risk/reward profile. Penny Stocks are companies that have very low share prices. You can buy some stocks for as little as 10c. It is much more common for a penny stock to trade from 10c to 20c than it is for Microsoft to trade from $25 to $50!

For this reason penny stock trading is becoming very lucrative for online speculators. They can still trade the stocks outright as well as making massive returns if they are correct about their view on market direction.

The only drawback with penny stocks is trying to pick which stocks to buy. I'm not that familiar with trading penny stocks, however, I know of a great site that provides stock picks for penny stocks every two weeks - . They have a free trial, so you can see for yourself whether penny stock trading is for you or not.

Penny stocks can be risky though - there's a reason why they're so cheap, nobody wants them! So, be careful to act on the right information.

Limited Risk

One of the biggest advantages option trading has over outright stock trading is to be able to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his/her right and simply let the contract expire worthless. Let me give you an illustration.

Remember our initial example of Peter buying a Microsoft Call option? Here are the details of that trade provided with the appropriate jargon;

Underlying: MSFT

Type: Call Option

Position: Long (i.e. bought the contract)

Strike Price: $25

Expiry Date: 25th May

At the time of the trade, Microsoft shares (the Underlying) were trading around $30. The Call option contract had been valued and was trading at $6.5 - known as the premium, but more on this under pricing.

So, from the above information we can conclude that after the 25th May, if Microsoft is trading above $31.50 we can make a profit on this.

Why $31.50? Because we paid $6.50 for the right to have this option in the form of a premium to the option seller. This means we must consider this in our profit estimate. Therefore we add the option premium to the strike price to determine our break even point.

A profitable trade

If Microsoft shares are trading at $40 by the 25th May, then we will elect to exercise our right to Call the shares from the option seller. Then we will be assigned Microsoft shares at the exercise price of $25, which is the same as if we actually bought Microsoft shares for $25.

Note: If we exercise our right and take delivery of the shares, this means that we will have to pay the full amount for the shares. So, the number of option contracts bought multiplied by the contract size multiplied by the exercise price. If you are planning to hold onto option contracts until expiry and take delivery, make sure you have the cash!

But, they are now trading at $40 at the stock exchange! So, you have Microsoft shares in your trading account with a purchase value of $25, yet they are trading at $40. So, you can sell them at $40 and make $8.50 per share.

Why $8.50? Remember the premium we paid? We have to consider that with our profit estimate.

Think about what happens as the underlying price continues to rise. You continue to make more and more money once the stock price has exceeded the strike price.

But what about the downside risk?

A losing trade

Let's imagine at expiration Microsoft shares are trading below our exercise price of $25 at, say, $20. Will we decide to exercise our right and take delivery of the shares and pay $25 per share? No way, because they're only worth $20.

So, we will just do nothing and let the option contract expire worthless.

What have we lost though? We lose the premium that we paid to the seller, which in this example was $6.5. That's it. A lot less than if the stock plummeted and we lost our entire investment.

What about if there is a stock market crash and Microsoft Shares are trading at $5 at the time of expiration? The same as if the shares are trading at $20 - nothing. We just let the option contract expire worthless and lose our premium - $6.5.

Limited Risk AND Unlimited Profit Potential

Can you see now how this type of strategy gives you the best of both worlds - both limiting your risk and at the same time leaving you open to make unlimited profit if the market rallies?

Not all option strategies have this payoff benefit. Only if you are buying options can you limit your risk. For option sellers, this is the reverse - they have unlimited risk with limited profit potential.

So, why would anybody want to sell options? Because options are a decaying asset, which you can read more about under the Time Decay section.

Insurance

Another reason investors may use options is for portfolio insurance. Option contracts can give the risk averse investor a method to protect his/her downside risk in the event of a stock market crash.

Where are Options Traded?

Option contracts are traded either;

• on a public stock exchange (also known as ETO's (Exchange Traded Options))
• implicity agreed between two parties (also known as OTC's (Over The Counter options)).

The majority of options, however, are traded via public exchange houses and these will be the options discussed throughout this web site. The OTC market is a complicated one, where traders from large institutions can create and trade non-standard option derivatives. They can, for example, add their own special rules such as: if the underlying stock trades as high as x then the contract terminates and the option is then worthless. This is known as a Knockout Option or a Barrier Up and Out Option.

Options are listed and standardized by the stock exchange and are traded by what is known as Serial Months. By standardized, I mean that the specifications that make up the option contracts are set by the stock exchange and cannot be changed.

Here is a snapshot of the August 2005 options for IBM.

The Call options are on the left, while the Put options are listed on the right. Notice the strike prices down the middle? In this case there are 24 contracts available for the public to trade that expire in August 2005. The total number of listed options for IBM at the time of writing (3rd July 2005) are 230. That's 115 call options and 115 put options.

What are Options ?

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

Calls and Puts

The two types of options are calls and puts:

A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market

There are four types of participants in options markets depending on the position they take:

1. Buyers of calls

2. Sellers of calls

3. Buyers of puts

4. Sellers of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers:

Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.

Call writers and put writers (sellers) however are obligated to buy or sell. This means that a seller may be required to make good on their promise to buy or sell.

For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can thus be even riskier. At this point it is sufficient to understand that there are two sides of an options contract.

The Lingo

To trade options, you'll have to know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.

An option that is traded on a national options exchange such as the CBOE is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in-the-money (ITM) if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value.

The total cost (the price) of an option is called the premium or option premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value), and implied volatility.