I’m going to get into some specific examples and show you how options react, based on the underlying changes of the ETF that we’re looking at – in this case, the QQQs. Before I do that, I just want to point out one additional thing that affects the price of an option.
The Delta, as I mentioned, affects the price of an option, based on the movement of the ETF that we’re studying. I mentioned that the December 11 $58 strike price calls have a Delta of 0.29. This means that if the ETF rises by $1, this option, currently selling for about 30 to 31 cents would rise 29 cents, based on a Delta of .29.
For every dollar rise in the ETF, the option would rise 29 cents, because of its Delta. The second thing that affects a value of an option to a much greater degree, is something called Vega. That’s the volatility of that particular option. The volatility, or the Vega, is listed here, along with the other Greeks, as they’re called, in the option market. The volatility is always quite a bit larger surrounding the at the money calls and puts.
In this case, the volatility of the at the money calls is .03. The at the money volatility of the puts is .03 as well. As you get out of the money, the Vega becomes much smaller. As you go deep in the money, the Vega gets smaller as well.
What volatility does is, it’s a measurement of the potential range in which this security will trade, until expiration. With 7 days left to expiration, in this particular example, with a Vega of .03, the market is saying that the potential for it to move in wide swings is fairly low. When volatility increases, you will see extremely wide bars on the underlying instrument. In other words, the movement of the stock or ETF that you’re watching will either shoot up dramatically, or decline dramatically, in a very large percentage move.
That gives us an idea that volatility could be increasing over a short period of time. There are a lot of trading opportunities available to us if that should happen. In later examples, I’ll give you some clues on how to look at volatility, how to determine whether or not volatility will be persistent during the next several trading sessions, and how you can capture profit opportunities from volatility.
It is an extremely important factor. When volatility is low, things tend to move very slowly through the market, generally higher. The broad indexes like the QQQs or the DIAs, which is the ETF for the Dow Industrial Average, or the SPY, for the S&P 500 – all of those financial instruments tend to move up, and up slowly.
When volatility increases, normally what happens is that there’s a drop in the market shortly thereafter. Volatility is an important pricing mechanism, and it’s also an important Greek to keep track of. It presents a lot of profitable opportunities.
Let’s do one other thing before we move on, and that is take a look at volume and open interest. I picked the QQQs specifically because they are a highly active set of options in the market. There is quite a bit of volume of each of these, in the QQQ series. You can see that the current volume, the volume in the column to the left, is all of the volume in the calls today.
You can see that the December $60 strike price traded at 1795 contracts. The $59 strike price had 13793 contracts traded. Those are just today. They also somewhat represent a bell curve. You can see that those deep in the money options rarely traded at all today, until you got down to the 50s. The 50s started trading at approximately 80 contracts.
Why would that be? Why didn’t any of these other in the money options trade? If we go back and take another look at the Delta, you’ll notice that almost all of the Deltas from the 50 onward have a Delta of 1. So, if you were interested in participating in a dollar-for-dollar move with the underlying stock or ETF, why would you pay more than the strike price at $50, for $7? Why would you buy something with a strike price of $40, for example, when it would give you the exact same Delta?
There’s no advantage to buying more Delta than you need. In this case, at the 50 level, probably early this morning, when it started trading, it was maybe just under 1.00. In that case, they wanted the most bang for their buck. They wanted to get as much Delta as they possibly could, by buying that option.
Buying the $49 strike option is no advantage. It’s more expensive, and it still gives you a one-Delta rating. If the market should rise by a dollar, they would also gain a dollar, as well. The percentage gain is better for the 50s. It’s the same dollar amount gained through Delta for the 49s, 48s, 47s, and so forth. There’s no reason why you would buy a deeper in the money call, in this case.