Option Greeks When Generating Income with Options
As I was describing the two popular ways to generate “rental” income by selling Covered Call options and Cash Secured Put options the one important aspect was left behind and that is the Greeks. When dealing with options people cannot ignore some of their properties as time flows.
One of the most important such properties is options Delta. This is nothing more than just a first order partial derivative of option price to the underlying price change, so just dP/dS, where P is option price and S is the underlying(/stock) price. The one interesting property of Delta is that it roughly corresponds to the option being in the money. Think about it, if a Call option represents a contract to buy a stock and if we are certain the contract will be executed at expiration then it means that a 1% change in the stock price would correspond to 1% change in the option price, but if for example we only think that the option will be executed with a chance of only 10% then 1% price change in stock price would roughly correspond to only 0.1% change in the option price. So Delta of 1 would roughly mean that the market thinks that the option is in the money and will be executed with almost complete certainty while Delta close to zero means the market thinks the option will almost certainly not be executed and therefore is out of the money.
So when we choose to sell a Call or a Put option it is always a good idea to pay attention to the option Delta. If it is high then it would indicate the option is quite expensive and the market assumes it is almost certainly will be executed. So selling such an option can boost the income provided the seller assumes the market is wrong and actually the option might not get executed. I personally like to sell Puts with high Delta when I actually want to increase a position in a certain stock for my overall portfolio. This way I get the income from selling the expensive Put that has high Delta and when Put gets indeed executed I buy that stock from the Put holder. So not only do I get the income from selling the Put but I also achieve the goal of increasing the stock holding of my portfolio. I like selling the calls with low Delta because usually I do not want to sell stocks so I get less income from selling Calls but I also usually are not forced to sell the Call holders my stock.
It is important to note that Delta representing probability of being in the money is only what the market believes in at any moment and not the objective reality. So of course if the stock is down on a given day this gives a boost to Put options and when the stock is up then it gives a boost to Call options on the given day. Therefore it is generally better to sell Calls when the stock is up that day and sell Puts when the stock is down on a given day. There are other important Greeks like Gamma which is the second partial derivative of option price to the underlying price change. Theta is the first partial derivative of option price to the time change. These two I use in specific cases. I will write a separate post about them. Then of course there is Vega and Rho which honestly I do not use much at this time. The reader is free to explore their applications.