My column in Wall Street Journal’s Market Watch on writing covered calls on dividend paying stocks for income.
A recent article about me in Market Watch about writing covered calls on dividend paying stocks.
Vega and Theta
The Vega or Lambda is the change in option price due to a 1% increase or decrease in implied volatility. Vega is the most commonly used symbol however, it is not a Greek letter, so some practitioners prefer to use Lambda, and they can be interchangeable. Short term options will have a lower Vega and will not be as sensitive to changes in implied volatility. Longer term options will have higher vegas and the price will be much more sensitive to changes in implied volatility. The Theta is the rate of decay of an option’s price over time. Long option positions, whether they are calls or puts will have negative theta which means that time will work against the holder of an option through the process of price decay. Short options will have a positive theta which means that the option writer or seller can earn slow profits over time through the price decay process. Shorter term options will have a higher theta than long term options and the price can decline rapidly through decay in the final weeks or days to expiration. Longer term options will have a lower theta and a lower rate of price decay. The rate of price decay accelerates rapidly as the option approaches expiration. Covered call writers who sell call options for income usually do better by selling short term options and benefiting from the rapid price decay. In the money options will also have a lower theta and less time value than at the money options. Out of the money options that have no intrinsic value will have a relatively high theta.
One element that can make option trading tricky is understanding how many different moving parts there are and how they can affect the price of the option. For example say you a very bullish on a stock and decide to buy a call option for upside participation and to control your downside risk. The stock may move, but the stock price movement can be offset by a decline in implied volatility, so the vega can work against you. If you’re looking at a bullish strategy you need to know how the implied volatility priced into the option will impact the price. If you buy when the IV is at a very high level, even if the price of the underlying moves, if the implied volatility declines it will impact your profit. If you have a position that is long vega you want the IV to increase, if you are short vega you want the IV to decrease.
Covered call writers want to be short theta, they want the option decay to work on their side. When you sell an option, whether it is covered or not, you will be short theta and also short vega, so you want the IV to decrease, and the underlying to not move too much so you can earn the theta or the decay of the option price with time.
The long call option is probably one of the simplest option positions to understand. The purchaser of a call is considered to be long a call option. The long call gives the investor exposure to the upside of the market while the risk is limited to the premium paid for the option. Long calls will have a positive delta and a negative theta. LEAPS or long term equity anticipation securities can be purchased up to three years out. If you are bullish on the market for example, but concerned about global events like
sovereign debt defaults, war or terrorism you could purchase a LEAP on an index like the S&P 500, if the market rises you’ll participate. In the event an unexpected event occurs and the market takes a big hit, your risk is controlled because what you have paid for the option is much less than if you had purchased the index fund outright. Considerations to be made when purchasing a long call include the price of the underlying, the implied volatility of the option, the strike price, expiration, delta and the theta or decay factor of the option. Remember the rate of decay accelerates rapidly in the final weeks prior to expiration. Investors buying call options as a limited risk stock substitute should use longer dated contracts to give the underlying more time to make the anticipated move and to minimize the negative effects of time decay. The options delta is also a primary factor to consider. The at the money call with have a delta near 50 which means that the option will move half of what the underlying does. Out of the money calls have lower deltas as they move out of the money, they also have lower prices which equates to less capital at risk but you also need a larger price movement in the underlying to profit. The delta is roughly equal to the probability of the option being in the money at expiration, so a call with a low delta, say a 25 delta call, will only have a 25% probability of being in the money at expiration. An in the money option will have a higher delta, but will also have a higher price meaning more
capital at risk. An in the money call with a 75 delta will have a 75% chance of being in the money at expiration. If the price of the underlying rises, that call’s delta will change at a rate given by the gamma and will go to 100 if the option goes deeper into the money. Generally tactical option investors buy high delta in the money calls as a stock or ETF substitute that have a high
probability of success. When buying deep in the money calls however, it almost never makes sense to pay more for the call than you would to purchase the underlying on margin or 50% of the price of the underlying.