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VIDEOOptions: Stuck in a Muddy Delta
What to do when spreads go in the money.
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For many novice and professional option traders, the use of basic vertical spreads is the bread-and-butter strategy in their playbook. Buying and selling 2 similar options helps reduce vega (implied volatility) and theta (time decay) risk to smooth out returns.
But the added consistency comes at a cost - the most obvious being that the maximum profit is limited. A more subtle setback is that even when a spread goes into-the-money, the maximum profit cannot immediately be realized.
If there's more than 2 weeks remaining, that profit might leave one dissatisfied, as it will be significantly smaller relative to the price change of the underlying stock. That's because the components that affect an options price -- such as time, volatility, and even the underlying price -- tend to be similar on both strikes.
Stuck in a Muddy Delta
Let's look at a quick example. If shares of Apple (AAPL) are trading at $52, the $50/$55 call spread with 60 days remaining until expiration would be trading around $3.30 off of a 25% implied volatility. The $50 call has a delta of 0.70 and the $55 call has a delta of 0.35. That gives the position a net long delta of 0.35 - meaning you can expect to "make" $0.35 for every $1 move in the underlying. (For more on delta, see this article.)
The result: The value of the spread will stay fairly flat unless it goes deep ITM, or there's less than 10 days until expiration.
Now, let's assume shares of Apple move to $56 4 weeks later. The $50 call is now worth $6.30 and has a 0.89 delta, and the $55 call is trading around $2.60 with a 0.59 delta.
So the spread is trading around $3.70, or a $1.30 increase on a $4 price move. Sounds like $0.35 to the dollar to me. But guess what? The net delta on the spread has actually declined to 0.30. Meaning, as it moves deeper into the money, it will only realize an incrementally smaller increase in value. It can be very frustrating.
As an alternative to selling the spread at a “discount” to the intrinsic value, one might look to buy a put spread to box the position and secure a profit. This will still leave some money on the table, but you may be able to squeak out a little more value.Twitter: @Minyanville/minyanville-markets-2
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