Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
DELTA & VOLATILITY IN COLLAR TRADES
I am a subscriber to S&C, and have traded stocks for several years. However, my knowledge of options is quite limited -- I recently found that a "collar trade" can work better than stops. Is delta an important consideration when using options in collar trades where I own the stock? Also, what about the volatility rating? Where do you find the rating for delta and volatility when evaluating which options are better than others? -- Ronald Rogers
If I understand correctly, there are three questions here, and I will address them one at a time:
1. How can I use collars to manage risk?2. Is delta an important factor when creating collars?
3. How does volatility affect strategy?
COLLARS VS STOPS
Both stops and collars can be used to manage risk. The stop-loss is simply an order placed with a broker to exit the position at a specific price level. The collar strategy, on the other hand, is a position that includes stock, puts, and calls. For every 100 shares purchased or held in the account, the investor will buy one put and sell one call.
The collar has limited risk, thanks to the put option. The put gives the investor the right to sell, or "put," the stock at the strike price of the option. For instance, if I own 100 shares of ZYX with the stock trading for $51 a share and buy one March 50 put, the put gives me the option to sell 100 shares of stock for $50 a share from now until the option expires in March. I am long the stock, long the put, and in a strategy known as a "protective put."
The collar is different than a protective put because it also involves the sale of a call option. Just as with the covered call or "buy-write" strategy, the call option will bring in premium. I sell one call for every 100 shares of stock.
So the collar is a combination of a protective put and a covered call. While the put serves as protection against a decline in the stock price, the premium received from selling the call finances the put option. Therefore, the covered call will cost less than the protective put. The downside? If the stock rallies above the strike price of the call option, the shares might be called away, leaving the investor holding nothing but a put option. In sum, the collar is strategy that has limited risk, but also limited reward.
DELTA
The collar trade can work well when the strategist wants to protect a position over a period of time, or when the strategist wants to profit from a gradual move higher in the price of the underlying stock. When the collar is used to protect an existing position, it is sometimes called a "vacation trade" because the strategist can buy a put, sell a call, and then go on vacation and not worry about the position.
However, some strategists use the collar to participate in a move higher in the underlying stock and, in this situation, understanding delta can be helpful. Delta is one of the greeks derived from an options pricing model. It measures the expected change in the option's value for each change in the stock price. For example, a call option with a delta of 0.45 will increase in value by 45 cents for each one point move higher in the stock price. Similarly, a put with a delta of -0.45 will gain 45 cents for each point decline in the underlying stock. Shares have delta of 1.00.
Understanding delta can help the strategist understand why the collar changes in value for each change in the price of the stock. For example, if a collar is created with 100 shares, selling a call with a delta of 0.50 and buying a put with a delta of -0.35, the overall delta will be 0.15. Therefore, the trade will gain 15 cents for each one-point advance in the stock. It will lose 15 cents for each point drop in the stock. So it has a bullish bias, which many traders seek when creating collars.
POSITION = DELTADeltas are always changing, and as they change, the strategist can make adjustments to the collar to keep a bullish bias. The adjustment can involve buying or selling puts, calls, or shares. In sum, delta can be useful when creating collars and is very important when the strategist uses adjustments as the stock price moves higher and lower.Long 100 shares of ZYX = +1.00
Long 1 ZYX put = -0.35
Short 1 ZYX call = -0.50
Total position delta = +0.15
VOLATILITY RANKING
Volatility is also an important factor to consider when creating collars. If implied volatility (IV) is high, the call options will bring in more premium and, although the put will also be more expensive, the high IV will generally work in the strategist's favor when creating collars with a bullish bias. However, there are other factors to consider, including which strike prices to use when looking at the volatility of the stock and the options. It is a topic we cover in detail in our advanced courses.
Finally, to find the delta and volatility of an options contract, you can use an options pricing model. There are several websites that offer free options pricing models. But if you are looking for more sophisticated screening and ranking, a more advanced software program like Optionetics.com Platinum site will make this type of analysis a lot faster and easier.
Originally published in the February 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2006, Technical Analysis, Inc.
Return to February 2006 Contents