By Derek Moore
The picture of the triangle above symbolizes delta. Delta represents the change in something else and is quite relevant when we talk options. You see, an option’s Delta represents what the change in its price will be due to a 1-point change in the underlying.
This is a concept we use in everyday life, but don’t call it by this name. Think of it as a rate of change. For example, when you’re driving at a speed of 35 miles per hour you are changing your position by 35 miles every hour. This is the same for options. Think of the option price as the position and Delta as the speed. The higher the Delta, the higher the amount option value moves versus the underlying security, just like your position changes the faster you drive. This is a simple form of calculus, but very important when it comes to option valuation.
We’ll need this info later, but for now that’s enough math; back to investing. Many of you participating in ZEGA’s Buy and Hedge Retirement Strategy may notice some trades involving closing current September expiration call positions in a simultaneous roll to a call that is further away from expiration. The reason for this is threefold.
Reducing Downside Participation with 2 Months Until Expiration
First, let’s explain how current calls have increased risk of downside giveback of their gains. When those positions were bought, they typically will have a Delta of around 55-65%. For example purposed, let us 55%, this means that for the next 1 point up move in the underlying S&P 500 Index, they would capture 55% of that move. It also means that if the S&P 500 Index were to move lower 1, they would only suffer 55% of that move.
Deltas on calls moves higher as the underlying goes up or moves further and further in the money. Currently those calls were sitting around an 90% Delta. Now you might say, that sounds great since we can grab 90% of the next 1 point higher. But, remember it works both ways. It would also mean that it would lose 90 cents for every point the S&P 500 drops. It’s a double-edged sword. As this is a predominantly protective strategy, we don’t like having exposure to lose 90 cents on every dollar drop.
We solve this problem of exposure by doing what is known as rolling the calls. Rolling to a further out expiration will reduces the delta exposure and reduces downside participation. This is also consistent with our portfolio delta targets, and upside market capture, of around 70% of upside moves while reducing participation in the downside by instituting downside limits.
Locking in Gains
This move essentially locks in unrealized gains and makes them realized for the portfolio. It is also a more conservative decision given that there are several binary market events in the coming weeks including the interest rate decision of the Federal Reserve. Since we are swapping out a higher delta option to a lower delta option, any market retracement would give back less than had we kept the current option positions.
Due to these being the September expirations, any material downturn would give up quite a bit of the gains with little time to consolidate and move back up. Plus, once a market turns lower and call options are less in the money, the return higher to its current value would have to do so starting at a lower delta. Simply put, on a recovery the rate of change in the premium based on market movements would be lower and it is unlikely there will be enough time to do so.
Laddered Expirations Where Possible
Finally, the third main point we’ll be discussing is that of expiration risk. Depending on the size of the portfolio within Buy and Hedge Retirement, ZEGA’s traders may look to spread out the expiration dates by instituting several tranches of call options that expire in a staggered fashion.
We call that laddering the expiration dates. While this may or may not impact your portfolio, doing so does create some flexibility on future adjustments while giving position time for the market to potentially move in a favorable direction on a portion of the account. It also allows us to roll calls more often locking in gains and raising downside limits.