We briefly introduced factors which influence the price of an option, such as delta, gamma, vega and theta. The value of a delta can be qualified as the correlation of the option and its underlying stock. If a stock goes up $1, and a call goes up 80c, and a put goes down 30c, delta of that call is 0.80 and delta of that put is -0.3. The deeper the strike price goes into the money, the higher the correlation, approaching 1 for call and -1 for put. Thus delta of a call is between 0 and 1 and delta of a put is between -1 and 0.
It is generally believe that the market will remain bullish in the next couple of years, most stocks will follow the trend and go up. Thus, I would like to discuss the riskiest short term call “strategy” first.
Short Term (less than 2 weeks) – Bet Earning Report with Deep Out of The Money Calls
If you are right about the market response to an earning report, you may achieve 100 fold or higher reward. Today is July 24, 2014. Visa will release its Q3 2014 earning report after market close. Current price of V is $223 and its Deep Out Of the Money （DOTM）call option, V Jul25′ 235 Call has bid/ask of 0.13/0.20， delta is 0.05，with unlimited reward and limited risk, that is $13 (use bid price) per contract. If V goes up to $224, the call will goes up 1 delta ($0.05), that is $0.18.
IF Visa’s ER greatly exceeded the expectation and its share price went up 10%, that is $245. Congratulations! You will instantly achieve 100 fold ROI , that is, a single contract will worth approximately $1000 (intrinsic value is already $245- $235 = $1, $10 X 100 = $1000). That sounds great, huh? However, what if its ER is great but market response is little bit lukewarm and V ONLY appreciated 5.5% to $235 by 4PM ET July 25 2014? I am sorry, all of the call became worthless.
Here is a breakdown analysis of Greeks and I just assign an subjective probability value for simplicity:
delta: Let’s just assume you are a stock guru, we have inside information, ER is fantastic and market responds positively (ER beat does not necessarily guarantee a positive market response). The probability of a winning delta is 75%.
gamma: The movement (of either direction) can be accelerated or decelerated, P = 50%.
vega: After earning report is released, the uncertainty diminished quickly, which will cause the collapse of vega and the depress the option price. P = 10%.
theta: Very negative when it is close to expiration day. Since it is Deep Out of The Money (DOTM), the chance of the underlaying climb to the strike are quite slim. P = 20%.
Overall, the probability of profit based on my subjective probability is 0.75%. Actually, OptionHouse provides a probability calculator. The probability to reach the break even ($235.13) is 10%, and the probability to achieve 100 fold ROI is 0.5%. How is that? The probability is approximately the same as 8 heads in a row!
1. Low probability, high ROI, limited loss with unlimited potential.
2. No time for followup actions： V Jul25′ 235 Call的bid/ask spread is 50%, it will expire tomorrow (July 25, 2014). It is too costly and has no time to take sensible followup actions.
3. Non-replicable: It seems easy to bet correctly once, but it is impossible to bet correctly consistently. Have you seen anyone who won lottery more than once?
4. Non-scalable: It is impossible to acquire large amount of these kind of DOTM calls. The maximum is $6760 for 338 V Jul25′ 235 Calls. When market makers (MM) see someone is accumulating, they will ruthlessly skyrocket the call price, this will definitely cut into your ROI.
Giving the extremely low P and high ROI, shall we play it? Personally I redeem it more like lottery. We all buy lottery, but the goal of buying lottery is entertainment, not investment or winning a large lump sum. We won’t using our down payment to purchase lottery tickets or this kind of DOTM calls. The DOTM call strategy can be served as a way of entertainment. With $13 a pop and an unlimited dream, it is not a bad game to play.
P.S: At 4:30 PM ET, V released better than expected earning report，but stock plummeted. It is very like the V Jul25′ 235 Call will expire worthlessly.