With option expiration two weeks away on the third Friday of the month, which I now call "pay day", I monitor closely all Covered calls and Covered LEAPS positions that are likely to be called out for a positive called return.
As an option approaches expiration the time value decay starts to accelerate, and on expiration day there is no time value left. During this period of accelerating time decay the option spread can be affected by what is known as the Delta Effect.
What is the delta of a stock?
The delta of a stock option is the rate of change of the option price with respect to the price of the underlying stock. It is the measure of how much an option price will increase or decrease for an incremental increase or decrease in the stock price. The delta of an option is measured on a scale of 0.00 to 1. The higher the option delta or closer it is to 1.0, the closer the option price will track the price of the underlying stock, cent for cent. If the delta of a stock was 0.400 this tells the trader that for every $1.0 move in the price of the stock, either up or down, the option will move $0.40 in the same direction.
So what is the Delta Effect?
The Delta Effect occurs when the underlying asset goes up in value faster than the close-to-the-money short term option, which is held short against the underlying stock or LEAPS. This effect is most prominent during option expiration because of the accelerating time decay of the short option. This effect produces additional return for the underlying option spread.
All that is needed is a catalyst, such as a positive news announcement, to spike the stock or underlying LEAPS. When the LEAPS position is deep in the money with a delta close to 1 it will perform exactly like the stock, but with leverage on your side.
Let's look at an example:
As I described in my recent article on TradingMarkets.com, one of my favorite option strategies is the LEAPS Diagonal Spread, which I prefer to call a Covered LEAPS Spread.
LEAPS (Long-term Equity Anticipation Securities) are equity options that extend option expiration out up to 2 years. When using this trading strategy you are replacing being long the underlying stock with being long a LEAPS option.
Therefore, when structuring this type of trade the delta of the LEAPS option is very important. A LEAPS option that is deep in the money is more desirable because the deeper an option is in the money, the higher its delta will be, and the closer it tracks the underlying stock. Option delta data is available on most option trading platforms and is usually provided with the option chain. This is a list of all option strike prices and expirations on a particular stock.
On April 3, 2008 I was able to exit a Covered LEAPS position on DuPont (DD | Quote | Chart | News | PowerRating) due to the Delta Effect and was able to generate a much higher return than my initial constructed called return of 5.6%.
Position Entry: (3/20/08)
Bought to Open: DuPont- January 2010 $30 call (WDDAF) @ $16.80 per contract, (Delta-.9434)
Sold to Open: DuPont- April 2008 $47.5 call (DDDW) @ $1.00 per contract, (Delta-.7180)
Called return: $1.00 per contract divided by $16.80 per contract equates to 5.6% or an annualized return of 70.53%, using the option expiration date 4/18/08.
Position Exit: (4/3/08)
Sold to Close: DuPont- January 2010 $30 call (WDDAF) @ $19.10 per contract.
Bought to Close: DuPont- April 2008 $47.5 call (DDDW) @ $1.75 per contract.
Profit on long LEAPS - Loss on short call ($2.3 per contract- $.75 per contract= $1.55 per contract.
Delta Effect Return: $1.55 divided by $16.80 equals a 9.23% return per contract or an annualized return of 241%.
Not only did I increase my return but I also freed up my capital for another trade. The Delta Effect is one great advantage of the Covered LEAPS strategy but to be effective the spread must be constructed for a positive called return.
Larry Gaines, founder of www.CallsandLeaps.com, has an extensive knowledge of the equity and option markets with over 25 years of trading experience. His experience includes managing one of the world's largest international oil trading companies for over 10 years. He first started trading options 20 years ago on cargos of North Sea, Brent crude oil. His specialty is trading covered calls and LEAPS.
