The reason delta is an important concept to understand is very well demonstrated by the movement of the calls we have been evaluating in this three-part series. Out of the money options have a low delta but also have a low cost. When you are anticipating a very big move in the near term, an out of the money option with a low delta can actually return the best on a percentage basis because it is initially inexpensive and its delta will increase dramatically as it moves further in the money.
In the video below the I will walk through the expiration prices of each of the three deltas we sampled in this series. The stock used was GLD an ETF that tracks gold prices. GLD experienced a dramatic increase in prices pushing all three strikes into the money. The out of the money option had a much higher percentage return than either of the other two options. In this case, the out of the money option made sense because the market was so volatile and gold is a traditional hedge against uncertainty. During "normal" or less volatile market conditions, the at the money or in the money option would have been the better choice because prices moves slower and the out of the money option has a higher probability of expiring worthless. Delta can help us make those decisions and to understand what the risk of a particular trade is today.
If you buy a call option of a stock, and the stock price rises but does not reach the strike price then that option increases in value.
Do people often sell their options before they reach the strike price in order to pocket the difference between the new and old premium? If they do, does this expose them to the risks of selling a naked call?
John Jagerson
- naked calls
|2009-11-04 09:56:10
No - if you sell an option that you already own you are essentially "selling to close" and your account will close that position not open a short one.
You can sell an option before expiration. If the market has moved in your favor then you will be able to sell it for a profit.
Edward
|2009-11-04 20:16:44
So basically, all options do is provide leverage? More gains to the upside, and more losses to the downside? The farther out of the money the more leverage?
John Jagerson
- Leverage
|2009-11-05 01:56:18
Yes and no. The way you are stating the question is pretty true but a bit over-simplified. If you are just buying options it is usually true that the further out of the money you are the more likely they are to expire worthless, however, they also cost a lot less. On the whole it sort of evens out. An at the money or in the money call or put will cost a lot more but also has a higher probability of being worth something at expiration.
A lot of it depends on why you are trading the option though. Protective puts for example is a way to limit the risk in your long stock trades. Selling or writing short calls (covered call) on a stock you already own is another way to limit risk. Selling or writing puts naked is just like a covered call and also has the same risk profile.
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