risk = (3.75 – 2.50) × 100 = $125 (Net debit).Breakeven = (95 – 1.25) = 93.75 (Higher strike price – net debit).Discussion: The maximum risk for a bear put spread is the initialdebit to enter the trade. Since a bear put spread combines the sale ofa put with the purchase of a higher strike put, the net debit will belower than when buying a straight put. The maximum reward in thisexample takes place if IBM closes at or below 90 at expiration. Inthis case, a profit of $375 occurs. This is calculated by subtractingthe initial debit from the difference in strike prices. The breakevenpoint is calculated by subtracting the net debit from the higherstrike. Thus, the trade makes a profit if IBM closes at or below $93.75at expiration.
MEDIA ASSIGNMENTWhen it comes to trading, practice really does make perfect. To learn theinner workings of the four strategies described in this chapter, take advantage of the My Portfolio section of the Optionetics web site to set up andtrack vertical spread trades. Just register at the site and you’re ready tostart searching for promising trades that will enable you to learn howthese strategies work using real-world markets.In addition, the Optionetics web site has hundreds of insightful articlesabout a multitude of topics that can be reviewed. Use the article search feature to find articles about the various vertical spreads. Though many articleswill have a recurring theme, we often learn best by repetition and slight variances in the way a topic is taught. Traders can also use the discussion boardson the Optionetics web site to get feedback and information from othertraders as well as from various Optionetics writers and instructors.
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VOCABULARY DEFINITIONSAsk: The lowest price acceptable to a prospective seller of a security. Alow demand for a stock translates to the market being offered down to thelowest price at which a person is willing to sell. Off-floor traders buy at theask price and sell at the bid price. Together, the bid and ask prices constitute a quotation or quote, and the difference between the two prices is thebid-ask spread. The bid-ask dynamic is common to all stocks and options.At-the-money (ATM): When the strike price of an option is the same asthe current price of the underlying instrument.Bear call spread: A strategy in which a trader sells a lower strike call andbuys a higher strike call to create a trade with limited profit and limitedrisk. A fall in the price of the underlying increases the value of the spread.Net credit transaction; maximum loss = difference between the strikeprices less net credit; maximum gain = net credit.Bear put spread: A strategy in which a trader sells a lower strike put andbuys a higher strike put to create a trade with limited profit and limitedrisk. A fall in the price of the underlying increases the value of the spread.Net debit transaction; maximum loss = net debit; maximum gain = difference between strike prices less the net debit.Bull call spread: A strategy in which a trader buys a lower strike call andsells a higher strike call to create a trade with limited profit and limitedrisk. A rise in the price of the underlying increases the value of the spread.Net debit transaction; maximum loss = net debit; maximum gain = difference between strike prices less the net debit.Bull put spread: A strategy in which a trader sells a higher strike put andbuys a lower strike put to create a trade with limited profit and limitedrisk. A rise in the price of the underlying increases the value of the spread.Net credit transaction; maximum loss = difference between strike pricesless credit; maximum gain = net credit.Bid: The bid is the highest price a prospective buyer is prepared to pay fora trading unit of a specified security. If there is a high demand for the underlying asset, the prices are bid up to a higher level. Off-floor traders sellat the bid price and buy at the ask price.Bid-asked spread: The difference between bid and offer prices. The termasked is usually used in over-the-counter trading. The term offered is usedin exchange trading. The bid and asked, or offered, prices together comprise a quotation, or quote.Credit spread: The difference in value of two options, where the value ofthe one sold exceeds the value of the one purchased to create a net creditfor the combined position.
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Debit spread: The difference in value of two options, where the value ofthe long position exceeds the value of the short position to create a netdebit for the combined position.In-the-money (ITM): If you were to exercise an option and it would generate a profit at the time, it is known to be in-the-money. A call option is inthe-money if the strike price is less than the market price of theunderlying security. A put option is in-the-money if the strike price isgreater than the market price of the underlying security.Intrinsic value: The amount by which a market is in-the-money. Out-ofthe-money options have no intrinsic value. Call Intrinsic value = underlying – strike price. Put Intrinsic value = strike price – underlying.Leg in: When a trader enters each part of a spread separately instead ofentering the trade as one order with his or her broker.Limit order: An order to buy a stock at or below a specified price or tosell a stock at or above a specified price. For instance, you could tell abroker, “Buy me 100 shares of XYZ Corporation at $8 or less” or “Sell 100shares of XYZ at $10 or better.”Out-of-the-money (OTM): Refers to an option whose exercise price hasno intrinsic value. A call option is out-of-the-money if its exercise or strikeprice is above the current market price of the underlying security. A putoption is out-of-the-money if its exercise or strike price is below thecurrent market price of the underlying security.Slippage: The difference between estimated transaction costs and actualtransaction costs. The difference is usually composed of price revisions orspread and commission costs.Time value: The amount by which the current market price of an optionexceeds its intrinsic value. The intrinsic value of a call is the amount bywhich the market price of the underlying security exceeds the strike priceat which the option may be exercised. The intrinsic value of a put is calculated as the amount by which the market price of the underlying securityis below the exercise price.Vertical spread: A spread in which one option is bought and one optionis sold, where the options are of the same type, have the same underlying,and have the same expiration date, but have different strike prices.
CHAPTER 6
DemystifyingDelta
SUMMARYIn this chapter, the reader is introduced to the basics of delta neutral trading. Two of the most important market characteristics—volatility and liquidity—are discussed at length. In addition, the Greek options term deltais explored in detail and the mechanics of delta neutral trading are introduced. In order to utilize the various strategies that can be created usingoptions, futures, and stock, traders need to understand how volatility andliquidity impact these trading tools.Delta neutral trading is a common way for floor traders to minimizerisk. However, retail traders can also use delta neutral strategies tomake profits while minimizing risk. In order to fully understand deltaneutral trading, traders must develop a strong understanding of deltaand how it is calculated. In general, long calls and short puts have positive deltas, whereas short calls and long puts have negative deltas. Onehundred shares of stock correspond to a fixed delta of plus 100 deltaswhen purchased and minus 100 deltas when sold short. A delta neutraltrade combines long and short deltas to create an overall position deltaof zero.
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QUESTIONS AND EXERCISES1. Locating opportunities for delta neutral trades depends on findingmarkets with ______________.A. High liquidity and high volatility.B. High liquidity and low volatility.C. Low liquidity and high volatility.D. Low liquidity and low volatility.2. True or False: The higher an asset’s volatility, the higher the prices ofits options.3. A market’s ______________ can be defined as the amount of volumethat enables a trader to buy or sell a security or derivative and receivefair value for it.A. Volatility.B. Equilibrium level.C. Support.D. Liquidity.4. True or False: Delta neutral strategies are suitable for day trading.5. A stock option’s delta can be calculated by ______________ and multiplying by 100.A. Dividing the change in the premium by the change in the price ofthe underlying.B. Dividing the change in the price of the underlying by the changein the premium.C. Multiplying the change in the premium by the change in the priceof the underlying.D. Multiplying the change in the price of the underlying by thechange in the premium.6. One hundred shares of stock have fixed deltas of ______________.A. Plus 50.B. Minus 50.C. Plus or minus 50.D. Plus or minus 100.
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7. Long call options have ______________ deltas.A. Positive.B. Negative.8. Short put options have ______________ deltas.A. Positive.B. Negative.9. As a rule of thumb, the deeper ______________ your option is, thehigher the delta.A. In-the-money.B. Out-of-the-money.10. ______________ options have a delta of plus or minus 50.A. In-the-money.B. Out-of-the-money.C. At-the-money.11. When an option is very deep ______________, it will start acting verymuch like the underlying stock.A. In-the-money.B. Out-of-the-money.C. At-the-money.
MEDIA ASSIGNMENTUnderstanding how delta impacts a trade is vital to learning how to tradedelta neutral. Though there are many trading-related web sites, therearen’t many sites that provide the delta for an option. If you have access tothe Optionetics Platinum site or if you use an options program from another source, take the time to learn about delta. If you don’t have any ofthese, you can use an options calculator to figure the delta of an option.Your assignment is to look at different options and decide what delta youthink would be associated with that option. After you have done this withseveral options, check the actual data to see how close you were. After awhile, you’ll be surprised how accurate your initial decision about thedelta is compared with the actual delta.
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VOCABULARY LISTDelta
Position delta
Derivatives
Skew
Liquidity
Tick
Long-term equity anticipationsecurities (LEAPS)
Volatility
SOLUTIONS1. Locating opportunities for delta neutral trades depends on findingmarkets with ______________.Answer: A—High liquidity and high volatility.Discussion: Delta neutral trades rely on magnitude of movementin the underlying security. High volatility often scares away newtraders; but an experienced trader usually thrives on volatility.When a stock or an index shows a lot of movement, this volatilityenables delta neutral traders to make profits even while minimizingrisk. However, in order to take advantage of high volatility, a tradermust understand the characteristics of volatility and delta. High liquidity is also needed to get your order filled at a good price whenentering and exiting a trade.2. True or False: The higher an asset’s volatility, the higher the prices ofits options.Answer: True.Discussion: Volatility tells a trader how much the stock is expected to move. This means the higher the volatility, the greaterthe chance of a move of sufficient magnitude in the underlying asset. An option premium is like an insurance premium, which meanswe pay more when there is more associated risk. If volatility ishigh, the stock is expected to move a great deal more; thus thepremium to enter a call or put is higher. A delta neutral traderthrives on high volatility, as it increases the chances of marketmoves of high magnitude, which provides for a number of profitmaking opportunities.
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3. A market’s ______________ can be defined as the amount of volumethat enables a trader to buy or sell a security or derivative and receivefair value for it.Answer: D—Liquidity.Discussion: When a stock or option has low liquidity, the price tendsto be skewed. Retail traders buy at the ask and sell at the bid, so it isimportant to find options with high liquidity so the bid-ask spread isnot too wide. Slippage is the amount of money lost by buying at theask and selling at the bid. With options that have low liquidity, thespread will often be large and it will be difficult to get fair value forthe options.4. True or False: Delta neutral strategies are suitable for day trading.Answer: False.Discussion: Though delta neutral trades are used by floor traders tohedge risk, it is usually not suitable to day trade this type of strategy. Irecommend trying to reduce risk and stress by utilizing delta neutraltrading techniques over a longer trading period.5. An option’s delta can be calculated by ______________ and multiplying by 100.Answer: A—Dividing the change in the premium by the change in theprice of the underlying.Discussion: Options are derivatives, so their price is derived fromthe movement of the underlying security. Delta measures the move inan option’s price as compared to a move in the underlying security.For example, if a stock moves $1 and the option moves higher by$0.50, then the delta is considered to be 50. An ATM option normallyhas a delta near 50, with ITM options seeing higher deltas and OTMoptions seeing lower deltas. A delta of 50 means that the underlyinghas a 50 percent chance of becoming in-the-money by expiration.6. One hundred shares of stock have fixed deltas of ______________.Answer: D—Plus or minus 100.Discussion: One hundred shares of long stock have a delta of +100.One hundred shares of short stock have a delta of –100. No matterhow the stock price fluctuates, the delta of plus or minus 100 will remain fixed. It is important to understand what the delta is for different securities so that combinations can be formed to create deltaneutral trades.
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7. Long call options have ______________ deltas.Answer: A—Positive.Discussion: A long call would have a delta between 0 and 100. A longcall can’t have a delta higher than 100 because the most a call optioncan move is point-for-point with the underlying security. The deeperITM the call option gets, the closer to 100 the delta will become. Thefarther OTM the option gets, the closer to zero the delta gets.8. Short put options have ______________ deltas.Answer: A—Positive.Discussion: With a short put, a trader profits as the stock moveshigher, and this means the delta is positive. (A long put would have anegative delta because the option makes money as the underlying declines.) Though in general Optionetics doesn’t advocate trading shortputs, or any naked options, there are times when using these types ofoptions is advisable to create delta neutral trades.9. As a rule of thumb, the deeper ______________ your option is, thehigher the delta.Answer: A—In-the-money.Discussion: As an option moves deeper in-the-money, it starts to mirror the movement of the underlying. A very deep ITM option will havevery little time value and will start to trade nearly point-for-point withthe underlying security. The opposite also holds true: An option thatis far OTM will see little movement for each point move in the underlying security.10. ______________ options have a delta of plus or minus 50.Answer: C—At-the-money.Discussion: In most cases, ATM options have a delta that is veryclose to 50. Another way of looking at this is to say that an ATM option has a 50/50 proposition of finishing in-the-money. A straddle is acommon delta neutral strategy that uses an ATM put and an ATM call,which produces an overall delta near zero.11. When an option is very deep ______________, it will start acting verymuch like the underlying stock.Answer: A—In-the-money.Discussion: An options contract will start to move point for pointwith the underlying once it is very deep in-the-money. Some traders
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like to use deep ITM LEAPS as a proxy for buying a stock. This is because they get nearly a point move in the option for each point movein the underlying security, but the initial capital outlay is smaller.
MEDIA ASSIGNMENTThis media assignment asks the reader to calculate the deltas associatedwith various options. Though we can find this data on various softwareprograms, it is good to have a basic understanding initially when lookingat various option trades. Take some time to set up a few trades using thestrategies already covered in this book and calculate each trade’s overallposition delta. Keep in mind how the delta impacts the trade. By thoroughly understanding this concept, you will be able to create winning options trades and have an easier time making additional profits by adjustinga trade back to delta neutral.
VOCABULARY DEFINITIONSDelta: The amount by which the price of an option changes for everydollar move in the underlying instrument.Derivatives: Derivatives are financial instruments whose value is basedon the market value of an underlying asset such as a stock, bond, or commodity. Examples of derivatives are futures contracts, options, and forward contracts. Derivatives are generally used by institutional investorsto increase overall portfolio return or to hedge portfolio risk.Liquidity: The ease with which an asset can be converted to cash in themarketplace. A large number of buyers and sellers and a high volume oftrading activity provide high liquidity. Liquidity is a concern for any moneythat may be required on short notice, whether for emergencies or forplanned purchases.Long-term equity anticipation securities (LEAPS): LEAPS arelong-term stock or index options with expiration dates up to threeyears in the future. Like all options, they are available in two types:calls and puts.Position delta: The sum of all positive and negative deltas in a hedgedposition.Skew: A descriptive measure of lopsidedness in a distribution. It is especially important for options trading when there is volatility skew and
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prices are greater or less than they should be at various strikes and/orexpirations.Tick: The smallest possible movement (up or down) in the price of asecurity.Volatility: The magnitude of price (or yield) changes over a predefinedperiod of time. The amount by which an underlying instrument fluctuatesin a given period of time. Options often increase in price when there is arise in volatility even if the price of the underlying doesn’t move anywhere. Volatility is a primary determinant in the valuation of options.There are two main types of volatility: historical and implied.
CHAPTER 7
TheOtherGreeks
SUMMARYThe option Greeks are a set of measurements that provide insight into atrade’s risk exposure. This chapter reviews the four basic option Greeks—delta, gamma, theta, and vega—while analyzing their trading applications.In addition, the chapter examines how intrinsic value, time value, andvolatility impact option premiums.The Greeks help options traders minimize risk by telling us how thevalue of a trade will change due to fluctuations in price, time, and volatility. An option has two types of value: intrinsic and extrinsic. Intrinsic valueis the real value of an option and is the amount an option is in-the-money.Intrinsic value is not affected by theta, or the passing of time. Extrinsicvalue, or time value, is impacted by theta. The deeper ITM an option is, theless extrinsic value the option has. An ATM or OTM option has no intrinsicvalue and is completely made up of extrinsic or time value. Since each option comes with an expiration date and as each day passes some timevalue is lost, options are called wasting assets. This is why it is importantto understand theta and how it impacts an option’s price over time.Volatility has two meanings in the options field—one being historicvolatility, the other implied volatility (IV). By understanding the volatilityof the underlying security, we can find discrepancies in pricing. Impliedvolatility is a major part of an option’s price, so when we see options thatare showing IV that is higher than normal, we can benefit by selling the option. The same holds true for options showing low IV compared to pastvalues, as we can buy options to benefit from a rise in IV.87
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QUESTIONS AND EXERCISES1. Option Greeks are a set of measurements that explore the______________ of a specific trade.A. Parameters.B. Delta neutral opportunities.C. Risk exposures.D. Risk-to-reward ratios.2. Name the four basic option Greeks.1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________4. _________________________________________________________3. Fill in the option Greek term next to its appropriate definition.Greek
Deﬁnition
__________
Change in the delta of an option with respect to the change inprice of its underlying security.
__________
Change in the price of an option relative to the price change ofthe underlying security.
__________
Change in the price of an option with respect to a change in itstime to expiration.
__________
Change in the price of an option with respect to its change involatility.
4. The two most important components of an option’s premium are______________.A. Intrinsic value and extrinsic value.B. Vega and extrinsic value.C. Intrinsic value and vega.D. Gamma and theta.5. For a call option, intrinsic value is equal to ______________.A. The strike price of the call option minus the current price of theunderlying.
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B. The strike price of the call option plus the current price of theunderlying.C. The current price of the underlying minus the strike price of thecall option.D. The current price of the underlying plus the strike price of thecall option.6. For a put option, intrinsic value is equal to ______________.A. The strike price of the put option minus the current price of theunderlying.B. The strike price of the put option plus the current price of theunderlying.C. The current price of the underlying minus the strike price of theput option.D. The current price of the underlying plus the strike price of the putoption.7. If a call or put option is out-of-the-money, the intrinsic value is equalto ______________.A. The strike price of the option.B. The price of the underlying.C. The price of the underlying minus the strike price of the option.D. Zero.8. True or False: The intrinsic value of an option does not depend onhow much time is left until expiration.9. Time value ______________ as an option approaches expiration.A. Increases.B. Decreases.C. Stays the same.10. Time value is also known as ______________.A. Delta.B. Gamma.C. Theta.D. Vega.
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11. The more ______________ an option is, the less it costs.A. At-the-money.B. In-the-money.C. Out-of-the-money.12. If a call option’s price is less than its exercise value, investors wouldbuy the calls and exercise them, making a guaranteed ______________before commissions.A. Margin.B. Credit.C. Debit.D. Arbitrage profit.13. On expiration day, all an option is worth is its ______________.A. Time value.B. Extrinsic value.C. Intrinsic value.D. Fair market value.14. The deeper ______________ a call or put option is, the more the optionmoves like the underlying asset.A. In-the-money.B. Out-of-the-money.15. Name the seven components that contribute to option pricing.1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________4. _________________________________________________________5. _________________________________________________________6. _________________________________________________________7. _________________________________________________________
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16. ______________ is defined as the amount by which an underlyingfluctuates in a given period of time.A. Risk-free interest rate.B. Liquidity.C. Dividend payment.D. Volatility.17. Name and describe the two main kinds of volatility.1. __________________________________________________________________________________________________________________2. __________________________________________________________________________________________________________________
18. Name three things understanding volatility can help you to accomplish.1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________
19. ______________ is the Greek term that represents volatility.A. Delta.B. Gamma.C. Theta.D. Vega.
20. Buying options before implied volatility ______________ can causesome trades to actually end up losing money even when the price ofthe underlying asset moves in your direction.A. Rises.B. Drops.C. Stays the same for more than one week.D. Stays the same for more than one month.
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21. When an option’s actual price differs from the theoretical price byany significant amount, you can take advantage of the situation by______________, expecting the prices to fall back in line as the expiration date approaches.A. Selling options with low volatility and buying options with highvolatility.B. Selling or buying options with low volatility.C. Buying options with low volatility and selling options with highvolatility.D. Buying or selling options with high volatility.
MEDIA ASSIGNMENTThe Greeks are an integral part of understanding the risk associatedwith various options strategies. As a result, it is important to grasp howthese factors impact a trade. One of the best ways to see how theGreeks work is to experiment with an options calculator. If you haveaccess to the Optionetics Platinum site (you can always sign up for afree two-week trial at www.optionetics.com/platinum), there is an options calculator that can be used. Or you can use the calculator available at www.cboe.com. By entering different variables for impliedvolatility, expiration, and strike price, we get changes in the Greeks.Seeing how the Greeks relate to each other is a great way to gain a better understanding of them and the risks associated with various optionsstrategies.
VOCABULARY LISTBlack-Scholes option pricingmodelDeltaExtrinsic valueGammaHistoric volatility
Implied volatilityIntrinsic valueThetaTime decayVega
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SOLUTIONS1. Option Greeks are a set of measurements that explore the______________ of a specific trade.Answer: C—Risk exposures.Discussion: Each Greek encompasses various aspects of an option’srisk. By understanding the Greeks you gain a better understanding ofthe risks of a trade. You can also make adjustments to a trade onceyou understand the delta dynamic. The key to successfully tradingoptions is to maximize profits while minimizing risks. Understandinghow to apply the Greeks is a prime factor in being able to accomplishthis task.2. Name the four basic option Greeks.Answer: Delta, gamma, theta, and vega.Discussion: Since each option Greek covers a specific risk, understanding each value is important to successful options trading. Deltais the most common and best-known Greek and rightfully so, but thisdoesn’t mean the other Greeks aren’t important. Depending on thetype of trade entered, a different Greek might be the most important.When selling short-term options, theta is very important. If you don’twant to see a sharp move in the stock, pay attention to gamma. Notonly is it important to understand each Greek individually, but it alsois valuable to understand how they relate to each other.3. Fill in the option Greek term next to its appropriate definition.Answer:Greek
Deﬁnition
Gamma
Change in the delta of an option with respect to the change inprice of its underlying security.
Delta
Change in the price of an option relative to the price change ofthe underlying security
Theta
Change in the price of an option with respect to a change in itstime to expiration.
Vega
Change in the price of an option with respect to its change involatility.
Discussion: These Greeks cover the basics of risk management foran option trade. Depending on the strategy implemented, different
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Greeks might have the most impact on the trade. We often find thatall the Greeks are important for certain trades, though one or theother might be the Greek that is the biggest risk to the trade. Once weunderstand the risks in the trade, we can make adjustments by offsetting the risks. For example, if we want to stay delta neutral and wefind that a trade has become heavy on delta, we can buy puts or sellcalls to adjust the delta back to zero.4. The two most important components of an option’s premium are______________.Answer: A—Intrinsic value and extrinsic value.Discussion: Intrinsic and extrinsic value combine to make up the totalvalue of an option. If an option is ATM or OTM it is made up completelyof extrinsic (time) value. If this is the case, the option has higher thetarisk. An ITM option is made up of both intrinsic and extrinsic value.However, as the option moves further ITM, its extrinsic value decreases—the more it is worth and the less time value it has. The fartherOTM an option gets, the less it is worth and the more theta is a problem.5. For a call option, intrinsic value is equal to ______________.Answer: C—The current price of the underlying minus the strikeprice of the call option.Discussion: A call option is ITM when the price of the underlying isabove the strike price. If a call option is ITM, the intrinsic value willnot be impacted by the passage of time. However, movement in theunderlying will have a dramatic impact on the price of the option.6. For a put option, intrinsic value is equal to ______________.Answer: A—The strike price of the put option minus the currentprice of the underlying.Discussion: A put option is ITM when the underlying is trading below the strike price. If a put option is ITM, the intrinsic value willnot be impacted by the passage of time. However, movement in theunderlying will have a dramatic impact on the price of the option.7. If a call or put option is out-of-the-money, the intrinsic value is equalto ______________.Answer: D—Zero.Discussion: Both OTM and ATM options have the largest amount oftime value for an option series. This means that theta will have amajor impact on the price of the option going forward. ATM optionsnormally have the most liquidity as well.
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8. True or False: The intrinsic value of an option does not depend onhow much time is left until expiration.Answer: True.Discussion: Only extrinsic value is affected by the passage of time.This is why it is important to understand what extrinsic and intrinsicvalue measure so that the proper risk management can be used. For example, you rarely want to be long options with less than 30 days untilexpiration. Why? Because theta has a more dramatic impact on timevalue during the last 30 days of an option’s life.9. Time value ______________ as an option approaches expiration.Answer: B—Decreases.Discussion: As the name infers, time has value. Thus, as time passes,its value decreases. However, time decay or theta accelerates in thelast 30 days of an option’s life. This is why we suggest buying optionswith at least 90 days until expiration so that time decay is not a majorfactor. We also do not normally hold long options once we have lessthan 30 days until expiration.10. Time value is also known as ______________.Answer: C—Theta.Discussion: Theta is the Greek that represents time decay and timevalue. Theta tells us how much the option will lose each day due to timedecay. If we sell an option, theta is positive. The option will increase invalue due to the passage of time and the impact of time decay.11. The more _____________