Delta, Volatility and Option Valuation
These are a few of my unfavorite things...
by John Brasher, CallWriter Publisher

We get asked occasionally why we don't include delta on our Real Time Lists™ of the highest-returning covered calls or even discuss it and why, for that matter, we don't make any use of the other "greeks." In addition, we don't use and never discuss the concepts of volatility skew and overvalued and undervalued options, nor do we even present implied volatility on our lists. Today's article discusses our feelings on these option concepts and explains why we never touch the stuff in the context of covered call trading.

Getting the Terminology Straight

Let's start with some definitions, so that we're all talking apples and apples:

The Greeks are a collection of statistical values (expressed as percentages) that give the investor an overall view of how a stock has been performing. The greeks are beta, delta, gamma, lambda, rho, theta and vega. The only one we find useful for covered call writing - and we really don't use it - is the beta, which measures how closely the movement of an individual stock tracks the movement of the entire stock market. We will consider delta in this article, but not the other Greeks.

Delta is the amount by which the price (premium) of an option changes for every $1.00 move in the price of the underlying stock. Call option deltas are positive, because calls have a positive relationship with the underlying stock (go up or down when stock goes up or down), and put option deltas are negative. A higher delta means that an option's price will have a greater reaction to a rise or fall in the stock price. A delta of 1means that the stock price and option premium move with each other penny for penny.

Overvalued and undervalued concepts assume that at a particular price an option is fairly valued; above that the option is overvalued, and below it, undervalued. Options with a high IV are overvalued and with a low IV, undervalued. However, valuation is a purely theoretical thing. It is a determination made by a mathematical pricing model.

Volatility and Implied Volatility. The term volatility (known as statistical, or historical volatility, or just SV) is a measure of the rate and magnitude of the change of prices (up or down) of the underlying asset - in this case, the stock - measured over time, usually twelve months. This is the amount the stock price actually moves over time. Implied volatility(IV) is the estimated future volatiliy in the stock's price. In other words, it is the option price's forecast of the underlying stock's expected volatility. The higher the premium, the greater the potential volatility implied, and vice versa. The Black-Scholes option pricing model calculates IV using statistical volatility and current market prices. IV is determined by plugging in current market prices of options, usually an average of the two nearest just out-of-the-money option strike prices. IV is a purely theoretical measure, however.

A volatility skew occurs where two or more options on the same underlying stock are showing considerable differences in implied volatility. There can be time skews (skews among the same strike over different expiration months) and strike skews (skews among different strikes with the same expiration month). The Black-Scholes option pricing model suggests that every option should imply the same volatility for underlying stock, but in practice this rarely occurs, because every option implies different volatility. In other words, volatility skews are pretty much the norm. Implied volatility often tends to be higher for out-the-money (OTM) and in-the-money (ITM) options compared to those at-the-money (ATM), in which case OTM and ITM options represent increased risk on potentially very large movements in the underlying; to compensate for this risk, they tend to be priced higher.

The Limitations of these Concepts in Covered Writing

The option professors love these option concepts. Do a Google search for any of them, and you will turn up any number of articles emphasizing their importance and suggesting that only untutored traders don't use them. So why don't we at CallWriter use any of these hallowed option valuation or measurement concepts in our covered call trading? Well, as traders we are pretty ruthless, and we reject anything, however hallowed, that isn't practical and doesn't make us money, as I will explain.

We have never considered adding delta or any Greeks to the lists, because we don't consider them helpful in trading, period. The reason is that the Greeks - delta in particular - are not significant numbers or measurements in and of themselves, but are only artifacts of the two real factors that mainly drive an option's premium:

1) Stock price
2) Implied volatility

There are other factors, but these are the main ones. Time remaining until expiration - another factor in option price - is signficant only when there is not a lot of implied volatility. Remember the old joke about the thrifty farmer who hung up a length of rope outside the kitchen window as his weather station? When the rope got wet, he knew it was raining; when it got stiff, he knew it was freezing; and when it swayed, he knew it was windy and knew which way the wind was blowing. Delta is like that rope.

We don't find delta very diagnostic, nor to offer any predictability as to future option price movement. For example, when a stock hits our Real Time Lists™ it may have a very high delta - merely reflecting the fact that IV is high. And then if IV collapses three days later, the result will be a substantial drop in the option's price - and a more-or-less corresponding drop in delta. But so what? Granted, observing that the delta has changed from 1.1 to .6 will tell you reliabily that IV has dropped, and may even provide a rough reckoning of how much IV has dropped, much like the farmer's rope. But both IV and the option price itself are better and more precise barometers of the current trading dynamics. Certainly, the drop in delta will not tell you how much you can make if you close the trade, but the option price will!

Nor will delta, in our experience, provide any reliable gauge of a trade's profitability at trade entry. Similarly, we have never seen any correlation between trade quality and delta. Since covered call writing is an incremental strategy, the key to success at it is to control losses, since getting good covered call returns is easy as falling off a log. Returns are irrelevant if the trader is taking losses. For that reason, our analytical process is geared mostly to avoiding losers. We just don't find delta of any use whatever in covered call writing.

Regarding the valuation of options, the most touted theory is to buy undervalued ones and sell overvalued ones. Many writers have stated that traders should no more ignore over- or under-valuation of options than they would ignore the value of a a car or house they planned to buy or sell. But on the other side of that admonition, would anyone sell a car or house at a price based solely on some mathematical model of its value? Or even based solely on comparable prices? No! Isn't a thing worth what the buyer can get and the seller will pay? This is my problem with overvalued and undervalued options. While paying attention to over- and under-valuation may make sense to straight option sellers and buyers, buyers in particular, it has no place in covered call writing.

We have never observed historical volatility and IV to be helpful in covered writing. Historical volatility is only a measure of past volatility; I am only concerned with what the stock is most likely to do while I am in the covered call trade. The stock chart is vastly more helpful in that regard than any historical volatility calculation. IV is a purely theoretical measure, and knowing the precise IV of an option has pretty much zero to do with whether or not the covered call trade works. In other words, a covered call trade works perfectly when the stock is called out at expiration. A covered writer profits from IV, of course, but hardly needs to know what an option's IV is when writing the covered trade. In other words, IV determines the premium - and thus the return - but not the success of the trade.

Volatility skew can be used to identify opportunities to buy and sell options of varying volatilities. But this is of no value to the covered call writer. A covered call write involves buying one stock and selling calls on it. A writer can sell different strike calls instead of selling all the same call and thus create a strike-blended or time-blended position, but the writer still only sells one option contract per 100 shares held. The covered writer's choice of which strike to sell is made on the basis of how much return is desired versus how much downside protection is needed, and a skew among the various strikes is meaningless. The nature of the skew provides scant clue as to the underlying stock's direction, either. For example, if the IV of the OTM calls is significantly higher than the ITM and ATM calls, this is not necessarily a reliable hint that the stock is headed up, any more than ITM calls with significantly inflated IV means the stock is headed down. It seems to me that , as with tea leaves and cow entrails, traders tend to see what they're looking for there. If volatility skew deserves a place at the table, it is for straight option traders who are not market timers - not covered call writers.

Here is an excellent example: suppose a medium-sized drug maker expects a life-or-death FDA ruling on a drug application in a few days, and we can expect a major movement in either direction, but don't know which direction. In that case, we would be interested in straddling the stock - but not writing a covered call. Since we don't know which way the underlying stock will explode, we dare not write such a stock; we might pick the wrong side. And we would not bother to look at delta, option valuation or any of the above factors in regard to this stock, because they will have nothing to do with the trade's result - they are only reflecting the market's awareness of potential volatility. Because of the impending event and its magnitude, we know without the bother of looking that delta and IV are high, and that the options will be overvalued. This scenario precisely illustrates my point. How can the options be overvalued? Overvalued compared to what? Compared to "normal" times when the stock is not facing life-or-death news? If the stock is likely to soon explode, isn't this call worth more than a call on a similar stock that is not expecting such news? Of course it is! Some writers would advise traders not to buy these options, because they are so overvalued, but to sell them instead. Yet if the stock explodes $50 on big news (as OSIP did in 2004), long calls would have been the smart play.

More to the point, in the above example we know why delta and IV are high and why the options are "overpriced"; we know exactly what impending event is driving them. They are merely reflecting that impending event.The rope is moving, so the wind must be blowing. In this example, what - of any use - did delta and IV tell us? They told us what we already knew merely from the high returns being offered - that something was afoot. Trust me, it is better to know what is driving IV than to know that IV is high. IV in and of itself is deaf and dumb.

Why do I say deaf and dumb? The answer is that high IV is a predictor of future volatility, but not a reliable one. That is, many of the stocks on CallWriter's lists offering those high returns don't move that much, and some not at all. A small percentage make a meaningful move. A very few explode or collapse. But I challenge anyone to identify - from delta, IV, option valuation or volatility skew - which of the stocks on our lists will move, how much and what direction they will move; or whether they will not move. It cannot be done. Neither can anyone use these bits of information even to find good covered call trades, because they are unrelated to trade quality and have no predictive power.

We prefer to make our decisions about straight options trades and covered call trades on the basis of technical analysis and market timing, with a few fundamentals (news in particular) thrown in. We don't care what the stock ultimately does, only what it might do during the limited horizon when we expect to be in the trade.

In short, it is my view that none of these option concepts makes money for the covered call writer. And if it doesn't make you money, what good is it? We don't dismiss these concepts entirely, and some of them may have useful applications in straight options trading - but not in covered writing.

Good luck and good trading!