Nicole Wachs explains this common source of confusion when reading an options chain.
Have you ever thought you are getting the hang of things, but then something comes along that seems to turn everything upside down? Today's post will examine option prices, delta, and how the change in their values can cause a great deal of confusion when reading an options chain.
ALL-STAR COMMENTARY
Delta represents the amount that your option price should change when the stock price changes by $1.00. To solidify this definition, let's use some real numbers. Below is an option chain for Goldman Sachs. Please look at the highlighted September 160 calls (in green).
Click here for a larger image.
The call delta is +0.557. This means that if GS stock rises by $1.00, the current call market of 7.15 - 7.30 should rise by approximately $0.56 on each side. The new market might be 7.71 - 7.86. If the stock declined by $1.00, the call price would decrease in the same manner. The new market could be 6.59 - 6.74. (Gamma would also affect the delta, which would affect the actual option's price. For more on this greek, please read Brian Overby's blog Understanding Gamma.)
In the same image, you might have noticed that the stock only rose by $0.50. How would the price of the option change in this case? The delta would be multiplied by the stock movement. (In the previous example, this step was omitted because the stock moved by $1.00 and anything multiplied by $1.00 remains the same.) Here is a formula to help you:
Stock move: +$0.50
Delta of call: +0.557
Stock move x delta = change in option price
$0.50 x +0.557Δ = +$0.27
If you look under the ‘Change' column, you will see that the number reads ‘0.27.' Feel like you're getting the hang of things now? Well, hold on for a curve ball coming your way! Let's look at the chain below. It's the same data from above, but the 125 and 135 calls are highlighted in red.
Click here for a larger image.
Both of these calls have a delta near 1.00. This means that the call price should change dollar for dollar with the stock. If the stock increases by $0.50, the call prices would increase by the same amount. So how on earth is the Change column displaying -4.85 and -4.92 respectively? Is the TradeKing model incorrect? Are the Exchanges displaying wrong information? Is the delta calculation useless?
No, no, and no. The Change column is only updated when that particular option trades. If there are no trades that day, the Change column will read zero (see call strikes of 100-115 above). This is also true for the Volume column. The Last column will display the price of the last trade, regardless of when it occurred. The Change of -4.85 refers to the last time the September 125 calls traded. Whenever that trade took place (yesterday, last week, last month, etc.), the Call price was 4.85 higher than it was today when it traded 35.05. The same thing applies to the September 135 call. The previous trade before today's trade of 25.70 was 4.92 higher. So the change reflects -4.92. These negative numbers do not refer to the impact of delta on the option's price when the stock moves.
Even though the Change column will only vary when a trade occurs, the Bid and Ask quotes of all options are changing dynamically as market conditions change, regardless of a trade taking place. Market conditions include changes in stock movement, time decay, implied volatility, and risk-free interest rates.
Why was the Change column correct for the 160 calls? This is the at-the-money (ATM) strike. In general, the ATM options are the most actively traded in the series. Therefore the Last column will usually reflect changes in the option prices more in-step with stock movement. The data shown here is coincidentally correct.
Many customers have asked me questions about reading option quotes on several occasions. I would be remiss without pointing out another source of head-scratching when looking at the Last column. If you notice, the last sales for both of these calls are lower than the current bid and ask prices. If you were looking to buy either one of these options, the ask price would reflect the cost you would pay, not the Last sale. The same goes for the bid when looking to sell these options. In almost any case you would not use the Last sale to determine the current market of any security. Always look at the full quote. The bid and ask reign supreme as the authority of where something is currently trading, NOT the Last sale.
To sum things up, the most important data to determine current price values are the bid and ask columns. The Change and Last columns of an options chain should often be ignored. Otherwise, you could suffer a needless case of agita.
I hope this post leaves you more wiser for the wear.
Regards,
Director of Education
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For a list of previous All-Star Trades, please click here.
Nicole's previous posts: Getting Familiar with Earnings Plays and Liquidity of FROs and FRO Trading Requirements
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 or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
This comment and any market data included here were prepared on September 5, 2008.
