When initiating a new trade I often start by buying a 30 Delta option. What’s so special about 30 Delta options? Many option courses recommend buying in the money (ITM) options of 60-80 Deltas. Are they wrong? Yes…and no. It depends on what you are trying to achieve. My system for trading options is all about reducing risk in an option position through the use of a technique I refer to as Delta Hedging (DH). I typically start a trade by buying a 30 Delta option and then as price moves higher I sell a further out of the money option (OTM) for around the same price that I purchased the original option for. That leaves me with a Vertical Spread that is anywhere from very low cost to zero cost or even a locked in profit. Sounds good but still no explanation of why a 30 Delta option. Let’s look at an example from the current $SPY option chain to explain my strategy.
It’s important to understand that the only way to determine the relative value of an option is to look at the implied volatility (IV) of that strike. I can then compare that to any other option in the option chain to see how much ‘bang for my buck’ that I’m getting. Below is a risk profile of SPY Jan2022 options with 294 days to expiration (DTE). I’m comparing the 60, 30, and 20 Delta Calls. It should be easy to compare their prices, right? The 60 Delta Calls should be twice the cost of the 30 Delta Call and three times the price of the 20 Delta Call. I mean, 60 is twice 30 and three times 20 so that makes sense. That does make sense but it’s not correct. It’s not correct because the further OTM you go on the Call side of an option chain, the lower the IV gets (in almost all stocks and non-inverse ETF’s). We’ve already agreed that IV represents the relative value of an option so if you look at the risk profile below you’ll see that the 30 Delta Calls are quite a bit less expensive than the 60 Delta Calls. The 20 Delta Calls are cheaper still. I can buy multiples of the lower Delta Calls compared to the 60 Delta Calls.
Hopefully you noticed on the above risk profile that, because the OTM options are cheaper and I can afford to buy more of them and still remain within my budget for this trade, I can get long as many as 125 Deltas for about the same price as 60 Deltas. That’s called leverage. Wait, so if I can get extra Deltas for the same price, why wouldn’t I do that? Also, why not just buy a crap-load (that’s a technical term) of 10 Delta Calls or even 5 Delta Calls? You could but let me also explain another definition of what Delta represents. Delta is an approximation of the probability of finishing a trade ITM. Not necessarily profitable, just ITM. So if I’m buying 10 Delta options they are way OTM and very unlikely to see price reach that level prior to expiry. But you can decide for yourself what Delta options you would like to buy when you initiate a new trade. I’m just here to tell you what I do! Below is the risk profile that shows a hypothetical trade. Let’s say that I bought a 60 Delta SPY Call at the close of the week’s trading. The next Monday, SPY rallies by 2.5% or 10 points. I’d likely take that opportunity to DH the position by selling the $10 further OTM Calls to convert the long Calls into a $10 wide Call Vertical spread for approximately a zero dollar cost. The next 3 risk profiles below show the approximate results of what the current profit and the maximum potential profit would be.
Those risk profiles are approximations as the 60 Delta options would perform slightly better than that in actual trading and the 30 and 20 Delta options slightly worse but emphasis on the word slightly. The lower Delta Call positions out-perform the higher Delta strategy because of the leverage that comes from owning more option contracts for the same approximate trade cost. I don’t worry that the lower Delta Calls are worse positions in terms of Theta because I’m using them to establish a higher profit upside in a directional trade. If I want to add more Theta I can always turn those positions into a Butterfly or Condor spread. But that’s for another lesson.
There is one other benefit to trading a strategy where you own additional option contracts. In this example, if I had initiated the trade with the 20 or 30 Delta options, I would’ve owned a 6-lot or 3-lot position. That offers the opportunity to partially exit the position while DH’ing the remaining lots. For instance, on the 30 Delta option, 1 or 2 of the original contracts could’ve been sold to take a profit while holding the remaining DH’d contract(s) with the potential of a very large gain.
The title of this post refers to the fine art of strike selection. There are always a huge variety of choices when initiating a new options position. A multitude of of strike/expiry combinations that can overwhelm if I don’t settle on a strategy that provides for a good potential profit over a variety of outcomes. The 30 Delta option choice does that for me in most situations. If I thought price didn’t have as much potential to make a large move I will tend to select a higher Delta option such as 40 or 50 to initiate a trade. If I think price could see a substantial directional move I might utilize the 20 Delta option strategy with a longer duration to increase the maximum profit potential.
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