Wednesday, September 2, 2009

Over-Writes: A Delta Perspective

After my covered call post, I find myself somewhat uninspired to delve into other subject matter. It seems my creative flame has been snuffed out for the time being. So, let's expound on the benefits of the covered call. Rather than taking the conventional route and pontificating on the well known advantages to covered call writing, namely monthly income and downside protection; I'm going to view things primarily from a delta perspective.

Suppose we were savvy enough to purchase 100 shares of AAPL back in April around $120 when the overall market was in the beginning stages of what we now know as one of the strongest bear market rallies to date. With AAPL currently residing at $165, we're currently the proud owners of a $4500 unrealized gain. A tidy sum to be sure...

Given that we're long 100 shares, our current position delta on AAPL is +100. On the bright side, as AAPL continues to rise, we're making $100 per $1 move. On the other hand, if AAPL were to fall in value we would give back $100 per $1 drop. After accumulating a pretty stellar gain in AAPL, rather than letting our hubris get the best of us, it would be prudent to hedge our position to minimize the bleeding that will occur if the bottom falls out of AAPL. In short, we need to lower our delta exposure.
From days back in my post on delta, I showed the following table illustrating the six core actions traders could make, categorized by delta:

Positive Delta (Bullish): Long Stock, Long Calls, Short Puts
Negative Delta (Bearish): Short Stock, Long Puts, Short Calls

If I possess a bullish position (like our AAPL long stock) and desire to lower my delta position, I can do so by entering an opposing negative delta trades. Let's take a look at all three choices...

Short Stock:
The first and simplest approach would be to sell part of my position. For example I could sell 1/2 of my position or 50 shares.

Original position: Long 100 shares Delta +100
Adjustment: Sell 50 shares Delta -50
New Position: Long 50 shares Delta +50

With my new position, I've cut my delta exposure in half so that if AAPL drops, I now only lose $50 per $1 drop in the stock.

Long Put:
How's about just buying a put option to protect part of my gains.
Original Position: Long 100 shares Delta +100
Adjustment: Buy 1 October 165 put for $7.50 Delta = -45
New Position: Long 100 shares and Oct 165 put Delta = +55

With my new position I've certainly cut down my delta exposure. In addition, by buying a put I'm now in a positive gamma trade, so my net delta will continue to decrease if the stock falls (my losses will decelerate) and my net delta will increase back towards +100 as the stock rises.

Next time we'll jump into the effect of a covered call on delta.

For related posts on Delta, check out:

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