Q & A – Key Points About Selling Options Part 13
Q & A – Key Points About Selling Options (Part 13)
(Q) Stephanie had a question – what level should the desired Delta be?
What level? So I’m thinking this question is what Delta should I be looking at when selling the options contract? Certainly, you know, this is a question that’s going to change from one trade to the next. One little trick a lot of people use; this is not mathematically completely correct, but one of the definitions of Delta is the likelihood that the option is going to finish ‘in the money’. I was actually taught that definition so it’s not a back-of-the-envelope type of thing. It’s a valid estimation that the market is providing to you on the likelihood of an option finishing ‘in the money’. So, a 30 Delta call option, the market is estimating there’s about a 30% chance that this option is going to finish ‘in the money’, and some investors will use that to help guide them to decide how conservative do I want to be. Certainly, the further you go ‘out of the money’ the lower your Deltas are going to be – that’s good. But, the premium you receive is going to keep going down and get less and less. So, you’re weighing those two factors against each other. Your confidence level in your opinion on the underlying, your motivation, your risk tolerance, and then maybe some semblance of that Delta and the likelihood of finishing in the money will help you lead to that decision. But no one concrete answer will come through, you’ll choose different Deltas depending on different circumstances.
(Q) A quick note from AJ on a covered call. Your stock can be called back if you are ‘in the money’ and you have dividend and there’s a dividend date. Please close it or roll it to a higher option price as you might be responsible to pay the dividends. So, if you start writing make sure you pay attention to dividend dates.
Yes, that’s a good point. So, if the option is ‘in the money’ and it is the day prior to the X date, and there’s no time value left in the option itself, then there’s a very good chance that you will be assigned. Of course, you could be assigned if it’s just ‘in the money’ in general, and this is actually a gray area. I could spend quite a bit of time on this, but just being ‘in the money’. If I was an option holder and the option was ‘in the money’, but there was actually time value in my option, I certainly wouldn’t exercise it. I’d sell the option and then I’d go ahead and buy the shares. You can capture both times and the Dividend, if there is time value in the option. If there’s zero-time value then yes, I would expect exercise to occur point well taken the day before X dates. If there is a dividend payment you need to be concerned that assignment could very well occur. If you don’t own the stock, of course you would owe the dividend if you did own the stock, your shares are a good call away and you wouldn’t capture the dividend.
(Q) Do market makers take opposite positions by selling or buying stock based on the number of contracts X Gamma of that position for every tick?
I was following that question till the end. So, the market maker is going to calculate the Delta exposure of the position that they just took and then sell or buy stock on the opposite side to offset the Deltas. Now, as the stock moves the Deltas are going to change and that’s where Gamma comes in. It’s not times Gamma, it’s ignoring Gamma today, but subsequently the Gamma effect is going to dictate whether this market maker has to re-hedge their position later in the day or tomorrow. Even though they haven’t traded any more options, they have to re-hedge because the Deltas have changed as a result of Gamma. Hope that made sense.
(Q) Jesse ask, if we choose to write contracts against commons that we own, would it be wise to sell weekly since they expire sooner?
Well, I can’t give advice, but I think this answer is pretty broad. And if to say, is it a smart thing to consider? Sure, if you sell weekly’s you’re going to have to go a little bit closer to ‘at the money’ to capture enough premium to make it worth your while. You might be going one and a half percent ‘out of the money’ to get an actual premium amount that is even worth taking on the obligation. That means if you get quick spikes in the stock price, you’re going to have to give that up and you’re going to see money left on the table. However, when I traded weekly options all the time, if I was selling a call option one percent ‘out of the money’ and I was actually also able to capture a half a percent of the stock price value in premium and I got a big pop. It was hard to complain about making one and a half percent in one week. So those are complaints that you know, you didn’t make as much as you otherwise could. Those are the complaints that I’ll take all day long. It’s a smart approach. You just have to be cautious because you’re selling your options so close to the ‘at-the-money strike’ you might be giving away your stock far before you want to.