In Part 2 we looked at a few examples of managing ITM covered calls from our All Stars Model Portfolio. As promised, I will discuss rolling calls using the Delta Strategy in Part 3 today.

The Delta Strategy is one of the strategies used in a recent ASX study on Australian Buy-Write Returns. The study back tested 7 different “buy-write” (another name for covered call) strategies over a fixed period (April 2005 to Dec 2011) and the Delta Strategy was found to be the best performing strategy.

The Delta Strategy begins with buying a stock and then selling a 5% OTM call. If the delta of the call moves above 0.85, the call is rolled up to another 5% OTM call.

To understand this strategy, we must first understand delta. The delta of an option refers to the sensitivity of the option value to share price change. For example, an option with a delta of 0.3 will increase by 30 cents if the price of the underlying share goes up by $1.00.  The delta of the underlying share is always 1 and the delta of an ATM option is normally around 0.5. Delta decreases as an option goes further OTM and increases as an option goes further ITM.

Below is an option chain for Wells Fargo (WFC) when the stock was trading at $34.80. A 5% OTM call would be at a strike price of $36.50. As there is no option with that strike price, we could sell a $36 call option. The delta for the Apr $36 call option is 0.3276, which means the value of this option will go up by 32 cents if the WFC stock price goes up by $1, i.e. to $35.80. The delta of this option will also increase to 0.5 when this happens, as this option will be very close to becoming ATM.

From the option chain above, we can also see that an option with a delta of close to 0.85 is the Mar $33 call option. If the stock price moves up $1, the value of this option will increase by 85 cents. Based on the current stock price of $34.80, this call option is 5% ITM.

From the above, we can infer that our sold Apr $36 call will probably have a delta of 0.85 if it becomes 5% ITM in a month’s time. This means the WFC stock price will be around $37.80. If we want to roll our Apr $36 calls to a new 5% OTM call, it will probably cost us $1.47 ($1.94 – $0.47) to buy this ITM call back. In return, we will have $3 ($37.80 – $34.80) of unrealised profit in our shares. By managing calls using the Delta Strategy, we could get to enjoy some of the capital gains in our shares, if our shares go up in price. This is because the delta of our sold call options will be in the range of 0.3 to 0.85, and hence will appreciate in value at a slower rate than the underlying stock, which has a delta of 1.

However, as mentioned in Part 2, this is all well and good if the price of the stock continues to stay up. If the stock price falls, all the unrealised profits in the shares will disappear but the cost of rolling up our options will remain a realised loss. For example, the Delta Strategy would not have worked very well if applied to Newcrest Mining (NCM) last year.

If we opened our covered call when the stock was trading at $22 in July and managed our calls using the Delta Strategy, we would have rolled our calls at least 3 times as NCM shot up by 36% to $30 in the next two months. However, the stock price fell back again to $22 three months later. A long only stock investor will be at breakeven today, but a covered call seller using the Delta Strategy may still have realised losses from rolling his calls. Assuming a cost of 50% of the unrealised gains in the shares, this loss would be $4 per share (($30 – $22) x 50%).

The loss could be even more if there is a big spread between the bid and ask price of the ITM option. Below is the option chain for NCM today. As you can see, the bid price for the April option with a delta of 0.85 is $2.25 but the ask price for the same option is $2.70, which is a 45 cent spread. If I want to buy back that call, I will have to pay the ask price of $2.70. This is another reason why I do not like to roll calls especially for thinly traded options because it can be very expensive to buy the calls back.

Conclusion

Using the Delta Strategy is fine when the stock is in a steady uptrend as it enables us to participate in some of the capital gains in the shares. However, it can be quite risky if applied in bear market rallies as shown in the NCM example above.

When I first read about the Delta Strategy, I was quite excited as I thought it could be a simple way to manage ITM calls, which can be easily learned by new covered call sellers. However, I had trouble applying it to some of my trades in real life, whenever I did not believe that the rally in the stock price would be sustainable.

Although the Delta Strategy was found to work well (outperformed long only portfolio by 60%) when applied to a universe of 30 stocks in the ASX study, I still prefer to manage my ITM calls on a case by case basis using the considerations I mentioned in Part 2 of this series.

Disclaimer: This post is for educational purposes only and should not be treated as investment advice. This strategy would not be suitable for stock investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek investment advice if required.

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