I'm kicking off today's post with a seismograph to highlight today's topic: delta and volatility, and how these two related concepts may affect a long call spread trade. It'll also help illuminate why trading spreads might offer an attractive alternative to just buying long calls online. First things first: what is delta?
The official definition of delta goes something like this: delta is the amount a theoretical option's price will change for a corresponding one-unit (i.e. one point) change in the price of the underlying security. (For a fuller explanation, check out my earlier posts on delta, a mini-series starting here.)
Going back to last week's example, we have the stock at 63.90 and a 60 strike call at 6.10, with a delta of .65. Using the definition above, that means if the stock goes from 63.90 to 64.90, in theory the option should move up .65, from 6.10 to 6.75.
Stock @ 63.90 --> 64.90
60 Strike Call @ 6.10 --> 6.75
Let's apply delta to the spread examples we've been discussing in this series. If you look up the deltas for each leg of the spread and then calculate the net delta of the position, you'll see our original spread example comes out to a positive net delta of 45.
XYZ @ 63.90
Calls Price Delta
55 10.50 .99
60 6.10 .65
65 2.90 .45
70 1.60 .20
Delta Analysis
Long 60 Call +.65
Short 70 Call - .20
Net Delta +.45
In other words, if XYZ moves from 63.90 to 64.90, delta tells us that, theoretically, the spread will move $0.45 upward, too.
Stock @ 63.90 --> 64.90
60/70 Long Spread @ 4.50 --> 4.95
This is the downside of putting on the spread as opposed to buying the call alone. If the stock moves in the correct direction right away, the spread (with a net delta of.45) will not reward you as quickly as the long call will (with a delta of .65). At the same time, as expiration approaches and the stock holding steady, the short OTM call will approach zero and the long ITM call will approach one. Think of it this way: if the long call is ITM, upon expiration it will get converted into stock. If the short call stays OTM, upon expiration it will become nothing. Since the diverging deltas for each leg reflect that, many traders use spreads closer to the expiration date than they normally would do when buying calls. They will treat a spread more as a short-term trade, going out only 30 days, say, when they'd usually go out 90 with a call alone. This works for two reasons: first, because time decay is not as much of an issue for a short-term spread, and second, because fluctuations in implied volatility are somewhat neutralized by the opposing legs of a spread.
Now consider this angle: what if implied volatility changes a lot unexpectedly? In that case, a long call spread usually looks better than a single long call. Because you're both buying and selling a call, the potential effect of that volatility crunch will be somewhat neutralized.
In short, there's good news and the bad news whenever you compare spreads to buying calls alone. Spreads are less battered by time decay and volatility crunches, but to get those advantages, you're starting with a smaller delta. Time-wise, spreads will typically max out closer to expiration, which may be a factor in your decision as well.
What's on tap for next week? I'd like to think of long call spreads as essentially synthetic collars. We'll compare P&L graphs of the two and see what other concepts come clear from that analysis.
Regards,
Brian (OG)
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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility there is no guarantee that this forecast will be correct.
