The Delta Acceleration
If you’re deep in the options world, chances are you’ve heard some extraordinary tales of traders multiplying their money by trading out-of-the-money (OTM) options. But if not, here’s a story from back on 17th May 2009 – election results were announced, with the UPA regime secured for another term; Dr. Manmohan Singh at the helm. Stocks like stability and so expectant was the market of a further rally on 18th May 2009 that Nifty had closed at 3671 before polls opened.
At the time of our trade beginnings, we were just a group of traders trading with our own funds and those from a few clients. Prior to 17th May, one of our partners took an immense risk by investing Rs. 200,000/- in far out-of-the-money options. This was a courageous move because nobody could accurately guess what would transpire from the general election. Besides him, we as well were eager to discover the outcome of his investment. All became clear when the results were revealed, and we all knew that he would earn some money on 18th May – but we had no way of knowing how much profit he would make.
18th May 2009, a day etched in my memory – markets kicked off at 9:55 AM (the market opening time back then), with a bang. The Nifty immediately reached its upper limit and the exchanges became stagnant. In no time, Nifty surged by approximately 20%, resulting in the closing of the index at 4321! Finding it too hot to handle, the exchanges decided to wrap up for the day at 10:01 AM, making it one of shortest working days of my life.
It was a golden opportunity for our dear colleague, and it is what traders like me dream of. At 10:01 AM on a glorious Monday morning, the value of his options was Rs. 28,00,000/- – a tremendous 1300% gain! This kind of trading can cause immense wealth in such little time.
Let me ask questions about this narrative to help us return to the main subject.
Make a note of this before we proceed:
Pre-development is the stage where the option has an OTM or deep OTM status. The delta here remains close to 0, regardless of any movement from a deep OTM to a standard OTM position. For example, if spot is 8400 and 8700 Call Option is Deep OTM; its delta will be around 0.05. If the spot then moves to 8500, the delta of that 8700 Call Option will still be small but non-zero.
If the 8700 CE has a premium when spot is at 8400 of Rs. 12, then upon Nifty reaching 8500 (a 100-point move), it should be expected that the premium will increase by 5 points (100 points multiplied by 0.05).
Thus, the new premium comes to Rs.17/-. The 8700 CE is no longer deeply OTM but only slightly OTM.
It’s significant to note that, although the absolute change in the premium value is relatively small (Rs.5/-), the percentage alteration for the Rs.12/- option has risen to 41.6%, and now stands at Rs.17/-.
In conclusion, since deep OTM options tend to offer a large return, the underlying asset must experience significant price movements for that to occur.
Recommendation – avoid buying deep OTM options due to their small deltas and the fact that the underlying needs to move significantly for the option position to be profitable. There are more profitable opportunities elsewhere. On the contrary, selling deep OTM options can make sense for this same reason, but we will explore when it is most suitable by exploring ‘Theta’ from a Greek perspective.
The initial take off and rapid acceleration represent the point when the option moves from OTM to ATM, offering the most significant return on investment with greater risk.
Suppose the Nifty Spot is at 9000, and we have a 9100 CE option with a slight out-of-the-money (OTM) status, having a delta of 0.3. The premium for this option is Rs.30.
To analyse the premium, let’s calculate the changes based on a 200-point increase in the spot rate, taking it from 9000 to 9200. As the option becomes closer to at-the-money (ATM), we can expect the delta to increase.
For the slightly OTM option:
Change in underlying = 200
Delta for 9100 CE = 0.3
Premium change = 200 * 0.3 = 60
New premium = Rs.90 (Rs.30 + 60)
Percentage change = 200%
This example demonstrates the high sensitivity of slightly OTM options with a delta around 0.2 or 0.3 to changes in the underlying asset. Traders have the potential to achieve significant returns by accurately predicting the movements of the underlying asset.
Let’s now consider the ATM option for the same 200-point move:
Spot = 9000
Strike = 9000 (ATM)
Premium = Rs.80
Change in underlying = 200
Delta for 9000 CE = 0.5
Premium change = 200 * 0.5 = 100
New premium = Rs.180 (Rs.80 + 100)
Percentage change = 125%
ATM options exhibit greater sensitivity to spot price fluctuations compared to OTM options. With their higher delta, even small movements in the underlying asset can result in notable changes in the option premium. However, it is important to note that ATM options are generally more expensive than OTM options.
Furthermore, as options transition from ATM to in-the-money (ITM) and deep ITM, the delta remains constant at 1. This means that regardless of whether the option is ITM or deep ITM, the delta remains at its maximum value of 1.
Let’s examine another scenario:
Nifty Spot = 9000
Option 1: Strike price of 8800 CE, ITM option, Delta of 0.7, and Premium of Rs.120.
Option 2: Strike price of 8600 CE, deep ITM option, Delta of 1.0, and Premium of Rs.200.
Change in underlying = 200 points, taking Nifty to 9200.
For Option 1:
Change in premium = 200 * 0.7 = 140
New Premium = Rs.260 (Rs.120 + 140)
Percentage Change = 116.67%
For Option 2:
Change in premium = 200 * 1 = 200
New Premium = Rs.400 (Rs.200 + 200)
Percentage Change = 100%
In this case, the deep ITM option closely tracks the movement of the underlying. The option premium mirrors the price change of the asset, making it a suitable alternative to a futures contract.
It’s important to carefully consider these factors when deciding to buy options, considering the sensitivity of different options to underlying price changes and the associated costs.
Thus, it is advisable to invest in Deep ITM options as they react similarly to the fluctuations of the underlying. This reduces your capital requirements; however, you must always ensure that your chosen contract remains Deep ITM (i.e. has a delta of 1) and is liquid for trades.
I think this chapter contains a lot of information, which can be overwhelming if you are just getting started learning about the Greeks. Take your time to absorb each piece of knowledge one at a time.
We need to uncover other possibilities associated with the delta, which we can do in the upcoming chapter. For now, let us round off this chapter by summarizing our discussion in a table.
This table will assist us in comprehending how various options respond to a particular shift in the foundation.
I’ve chosen Bajaj Auto as the underlying, with a current price of 2210. We’re anticipating a 30 point movement to reach 2240, and we have plenty of time left before expiry so there should be no issue with time constraints.
It is evident that each option reacts differently when considering the same action regarding the underlying.
I have nearly concluded this chapter, and hopefully you are now able to answer the questions I asked earlier. Revisit them and see how far you have come.