How to Defend Your Options Profit

by Tyler Craig | August 31, 2011 1:21 pm

To successfully weather the market gyrations, traders must understand the risk.   For those focusing on directional risks, becoming acquainted with “delta” is not only a necessity, it could change your entire perception of how to both measure and mitigate risk.

Delta can be thought of as the great equalizer, the common denominator among the variety of trading vehicles such as stocks, options and futures.  Though delta is multi-faceted, the definition in focus is as a measure of a position’s sensitivity to a $1 change in the underlying stock.

Consider how delta may come into play in the context of the 900-plus point rise the Dow Jones Industrial Average has experienced over the past eight days.  Since the market is beginning to look a bit stretched to the upside, traders possessing bullish positions which have captured notable gains over the past week may consider lowering their delta.

Suppose a trader originally purchased one October 190 call option on AMZN for $14.  Due to the veritable explosion experienced in recent days, the call option has more than doubled in value to $29.   From a risk perspective, the delta currently stands at +79, which means the trader will give back $79 of profit for each dollar drop in AMZN stock.  With the sustainability of the parabolic rise in the market in question, now may be an appropriate time to develop a more defensive posture. In short, we want to lower the position’s delta.

The following table outlines the six choices facing traders and the affect they have on a position’s delta.

To reduce the positive delta of the AMZN call option we would be looking to add negative delta, so focus on the right half of the chart.  Here are three adjustment examples along with their affect on our AMZN position.

Short Stock

Long Oct 190 call: delta +79
Short 50 shares of stock: delta -50
New position: delta +29

Short Call

Long Oct 190 call: delta +79
Short Oct 220 call, delta -47
New position: delta +32

Long Put

Long Oct 190 Call: delta +79
Long Oct 210 Put, delta -40
New position: delta +39

Yet another option entails selling the Oct 190 call option to lock in the profit and purchasing a higher strike call option, such as the Oct 210 call, which is not only cheaper, but also offers a lower delta position.

At the time of this writing, Tyler Craig had no positions on AMZN.



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