Investing

Use the (Delta) Force, Young Investor

By Lee Lowell  |  June 28, 2018

My last few columns have focused on buying deep-in-the-money (DITM) call options and why I believe it’s a superior strategy compared to buying stocks the old-fashioned way.

With the help of a hypothetical trade in Microsoft (Nasdaq: MSFT), we saw that not only can you reduce your risk in the trade by 77% with a call option, but you can also boost your returns by 400%. I don’t know about you, but that’s a big number to me.

We received some questions about “delta” and why it’s so important when picking the option’s strike price.

We referenced delta as a number that represents the relationship between the change in an option’s price to the change in the underlying stock’s price.

Deltas range in value from zero to 100%. If you want your chosen option contract to move with the market, you should choose a delta with a higher number. For example, a 100% delta means the option contract will move in perfect lockstep with the stock.

But how do we know it really works?

We can use a trusty option calculator to compare results.

In the Microsoft trade, we picked a DITM call option with a 91.4% delta.

We’re banking on a situation where, for every $1 move in MSFT stock, the option price changes by at least $0.91 per contract.

Take a look at the first graphic below, which depicts the January 2019 $80 call option. This contract has a current value of $22.27; the stock trades at $101.50 per share. Three figures are circled.

In the second picture below, we’ve raised the price of MSFT by $1 per share to its current level of $102.50.

You can see the call-option value has increased by $0.92 per contract, to $23.19.

The numbers don’t lie. Delta works as it should!

You might also notice the change in delta itself between the two scenarios.

As stock prices rise, call-option delta values will rise too. This makes your call option work even better.

By the way, you can view these option calculators for free right here.

But why choose an option with a delta that’s above 90%?

As I mentioned previously, a high delta will assure you of option price movement. What’s the point of buying a call option if its price isn’t going to move?

Many novice traders focus on buying out-of-the-money (OTM) call options solely because they’re very cheap. This is a big mistake and a sucker’s game.

Sure, the option is cheap. But the Delta can be as low as 5% or 10%. You’ll hardly see any movement in the option’s price even if the stock rallies.

Plus, you’ll need the stock to make a big move by the expiration date for you to break even on the trade. That’s a tall order.

You’ll kick yourself for making those kinds of trades when you see how rarely they pay off.

Do yourself a favor: When thinking about buying a call option as a substitute for a stock, choose a DITM with a delta of at least 90%. You’ll thank me for it.

Until next week…

Lee Lowell

Lee Lowell

A former Wall Street insider and floor trader, Lee Lowell has worked in the market for nearly 30 years now. He began his option trading career in 1991on the floor of the New York Mercantile Exchange (NYMEX) in New York City.MORE FROM AUTHOR