Option Trading Strategy FAQ
You have questions about an Option Trading Strategy, we have answers to your questions. See if these cover what you are looking for.
Q: Why didn't my option move as much as the underlying stock?
A: Options will not move as much as their underlying stock unless they are in-the-money and/or very close to expiration. There are valid mathematical reasons for this. The amount an option can be expected to move (all other conditions being equal) given a 1-point move in the underlying stock is called delta. Delta is derived from the Black-Scholes formula for pricing options and represents roughly how much the option behaves like the underlying stock. A delta of .50, for example, means that an option can be expected (all other things being equal) to move about fifty cents for every $1 move in the underlying stock. Delta will change with time to expiration as the option moves more in- or out-of-the-money, and will also be affected by the volatility of the underlying stock.
Q: When an underling security (stock) is up, why do some call options actually fall in value for the day?
A: There are 6 inputs that determine an option's value: stock price, strike price, time to expiration, interest rate, dividend yield and volatility (over the life of the option). Normally, if the stock price goes up and the other factors remain the same then a call option also goes higher. So if the call option has gone down, then one of the other factors must have changed.
The passage of time or a dividend payment can certainly push an option’s value lower. The real wild card in option pricing is volatility. Sometimes, the market will bid up the volatility in anticipation of a market-moving event such as earnings release or a change in interest rates by the Federal Reserve. After the event, the volatility (and hence the option price) often drops sharply, even if the news helps the underlying move higher.
Q: How does "deep-in-the-money" differ from just "In-the-money"?
A: When someone refers to a deep-in-the-money option they are referring to a call or a put with a delta close to 1.00 (or -1.00 for puts). This option moves very close to a one for one ratio with stock movement up and down, and is often viewed as the equivalent of long or short stock. If an option has a delta closer to say 0.75, (or -0.75 for a put) that option is also considered in-the-money. The difference is that although these options will "move" with the stock, they will not move at the same one to one ratio. Instead, if the stock went up $1.00, we could expect the 0.75 delta calls to gain $0.75.
Q: What are the advantages of "vertical spreads"? And, are there any disadvantages? Is this a good option trading strategy?
A: The vertical spread consists of buying one option and selling another with a different strike but both expiring in the same month. One advantage of these option strategies is knowing what the risks and rewards are for that position. Another advantage of a vertical spread versus a single option position is that it is possible to put a cap on the amount of risk the option writer (seller) assumes, and decrease the costs of the purchase if you are an option buyer. The biggest disadvantage to these option strategies is that while it is very effective on limiting risk it also puts a limit on potential profit. You as the investor or trader must determine if the trade off between risk and reward is right for you and your trading plan.
Q: Can I purchase a spread by purchasing an (ATM) at-the-money LEAPS call, and selling a front month (OTM) out-of-the-money call? Is this a good option trading strategy?
A: Yes, the option trading strategy you described is also known as a "diagonal call spread." When considering implementing option strategies like this, you should be aware of the risks associated with the strategy, along with the (potential) rewards. In the worst case scenario, should you be assigned on the front month call and then exercise your LEAPS to cover the assignment, your loss would be the net debit paid to establish the position less the difference between the strike prices of the two options.
It’s more difficult to establish a maximum gain for these option strategies. The best case scenario is for the stock to go sideways or gradually rise over the life of the LEAPS call, thus allowing you to roll out your front-month option every month at a credit.
| Looking for something specific? Search Our Site! |
| Return to Options Trading FAQ from Option Trading Strategy FAQ |