By Steve Papale
Tough week for my basketball bracket. But I won’t dwell on that. It seems now that Kentucky is out of the tournament that the entire team is declaring for the NBA draft. Last year 7 players declared from the team that made it to the final four. This year after getting bounced early with a young team everyone is looking to go pro – even the walk-ons. Apparently a new loophole allows players to test the waters without losing eligibility for college play.
For nearly all options traders adjusting options positions is a key part of risk management. As markets move around most of us maintain a strict level of risk. Most of the time adjustments come in the form of buying or selling deltas. Occasionally we are faced with a decision on which strike to trade. For example, if the underlying has moved up, we may have deltas we need to buy to lower risk. When determining which strike to trade one criteria to consider is how much we are paying for the deltas we are buying, known as dollar delta.
Dollar delta can be thought of as how much delta I can buy for a given amount of money. Say I have a position I need to buy 200 deltas for a risk adjustment. And say there are two strikes I am looking at. On strike 1, the calls have a 20 delta and are trading for $1. So in order to buy the number of deltas I need I would buy 10 calls at strike 1 costing $10. At strike 2 the deltas are 25 and are trading at $1.35. To hedge my position here I would need to buy 8 calls (8×25=200) for $1.35 each or a total of $10.80. Each purchase lets me buy the required number of deltas to hedge but by buying the calls at strike 1 I only spend $10 compared to $10.80 at strike 2.
The reason for the price disparity is due to the vertical skew. As we know, in equities, implied volatility decreases as we move up in strikes and increases as we move down in strikes. We can use this price relationship to allow us to more efficiently purchase deltas for adjustments. However be aware that for options with lower IV, deltas tend to move less with a given move in underlying (gamma). This means that the hedging affect of the option can be less than desired as the underlying stock moves. In the end look at the relative pricing of options but also consider the gamma and how much protection will be produced for any given move.