Wiser Trader Stocks and Options Newsletter

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Issue No. 79  June 5, 2006                            Prescott, Arizona                       Systems@WiserTrader.com

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1.0   Trading

     

      Selecting options based on the Black Scholes formula or implied volatility can be quite complicated.  There is a simple way to tell which option will give you the highest trading return.

 

1.1 Delta

 

      When selecting options for trading, it pays to look at the ratio of delta to the options premium.  Delta is the dollar amount of a change in the option premium for each dollar change in the underlying stock price.  When the stock price moves in the direction of trade, up for calls and down for puts, the highest ratio of delta to the option premium will provide the greatest percentage return on value.  It sounds logical.  Right?

 

      It might surprise you to know that options having the highest delta do not necessarily provide the highest trading return.  The highest values for delta are found when options are deeper in the money.  However, premium values increase faster than delta as options move deeper in the money.  For options lying farther out of the money, premium values decrease faster than delta.  The net result is that the highest ratios of delta to options premiums occur for low priced out of the money options.  Of course, one has to check the actual ratio of delta to option premium to be sure to avoid deltas of zero for options that are so out of favor that they receive no bids. 

 

     A similar counter intuitive effect concerns expiration dates.  Ratios of delta to option premium are highest when the expiration date grows nearer.  The option premium declines faster than delta such that the highest delta to premium ratio occurs for near expiration options.  Here one has to be wary of exponential declines in premium values during the final month.  When trading, you do not want to hold near term expiring options more than a few days. 

 

      Many students are taught to select at the money options that are expected to deliver trading profits at least one month before expiration.  However, this prevents one from trading options for many higher priced stocks because at the money options with long expirations can be quite expensive.  By looking for the highest delta to premium ratios, one can find the highest returns at affordable prices.  Values of delta for any option can be found at Etrade.com using the link https://us.etrade.com/e/t/invest/quotesandresearch and selecting “Greeks” in the “Select Chain” pull-down menu.  

 

      The listed value of delta takes into account all five elements that the Back Scholes formula takes into account when calculating the fair value of an option:

 

  • Stock Price
  • Strike Price
  • Time remaining until expiration
  • Current risk-free interest rate
  • Volatility

 

      The actual premium price can be above or below the fair value of an option.  By looking at the ratio of delta to the actual premium price, a clear assessment can be made of the probable trading return

 

 

 

© 2006 Desert Mountain Systems, LLC.  Members of wisertrader.com are neither licensed brokers nor licensed advisors.  Trades discussed represent recommendations made by the editor for the wisertrader.com portfolio.  The newsletter and web site are for information only and should not be considered as personal advice.  While it is believed that the posted information is factual, mistakes can be made in transcription.  Investors should trade stocks only after verifying all information and consulting with a licensed broker or adviser.  Desert Mountain Systems markets third party trading systems but has no other affiliation with trading system companies. 

   

 

   

1.2 Filter Studies

 

      Continuing with filter performance studies, the latest 1 year period is shown at the bottom of Table 1A.  Details of the filters can be found on the web site.  Currently we are tracking filter performance with the S&P 500 Index 30-day SMA (simple moving average) relative to its 200-day SMA 1 month prior to the dates listed.  The ongoing hypothesis is that although stocks wee selected a year ago, portfolio performance is strongly influenced by behavior of the S&P 500 within the past month.

 

 

Table 1A

1 Year Filter Performance Using No Trailing Stop

Year Ending

1 Year S&P500 Gain

Month Ago S&P 500

SMA 30 vs SMA 200

Growth $15-$40 Filter Gain

Growth >$40 Filter Gain

Absolute Value Filter Gain

Relative Value Filter Gain

9/02/05

9.4%

+2.8%

60.1%

40.7%

19.3%

50%

9/30/05

8.6%

+1.8%

25.4%

61.4%

12.3%

24.1

11/04/05

8.0%

-0.1%

8.2%

14.8%

4.4%

-0.6%

12/02/05

6.2%

+1.9%

24.6%

9.6%

17.0%

34.7%

01/06/06

8.2%

+4.1%

39.8%

50.3%

27.8%

28.3%

02/03/06

6.1%

+4.2%

34.8%

60.7%

11.5%

34.3%

03/03/06

5.7%

+3.5%

32.7%

26.4%

11.0%

29.7%

04/07/06

9.5%

+3.3%

25.2%

61.2%

16.1%

18.4%

04/28/06

13.2%

+4.0%

95.0% *

19.9%

12.2%

32.0%

06/02/05

7.7%

+3.8%

32.0%

7.1%

40.7%

85.0%

* Only 2 stocks were filtered for this group

 

 

      The recent S&P 500 move towards its 200-day SMA is shown in Figure 1.  Although the month ago 30 day SMA was 3.8% above the 200 day SMA, the sudden down move took a toll on higher priced growth stocks. Lower priced growth stocks and value stocks faired much better.

 

 

FIGURE 1A

 

 

      The data continues to confirm that stocks selected by either filter do best when the S&P 500 remains several percent above its 200-day SMA for the most recent month.  The performance shown in Table 1A is for cases where no trailing stops were used.

 

 

1.3 Trailing Stop Settings

 

     Table 1B shows how profits change as trailing stops are widened from -10% to -100%.  One factor in such performance is that the S&P 500 has been in a bull market over the past year, all be it with a saw tooth rising wedge pattern.  Another factor is the quality of the filters themselves. 

 

      Stocks were filtered 1 year ago.  In some cases, a fixed nominal trailing stop setting X% can be improved upon by applying a trailing stop to each individual stock based on its highest percentage gain.  The variable value applied to stocks individually is,

 

        Variable trailing stop percentage = Highest_%Gain / 3 - X%        

 

       This effectively tightens the trailing stop as the stock price rises in order to preserve gains.  The variable trailing stop percentage is not allowed to expand wider than -X% or any narrower than -10%.  For this group of stocks, fixed and variable trailing stops gave similar results over the past year.  A slight improvement is more likely when the trailing stop setting is narrower than -35% in an up trending market.  Results depend on market behavior.

 

 

Table 1B

1-Year %Gains with Variable and Fixed Trailing Stop Settings

 

Absolute Value

Relative Value

Growth $15 to $40

Growth > $40

“X“ Nominal Stop Setting (%)

Variable Trailing Stop

Fixed Trailing Stop

Variable Trailing Stop

Fixed Trailing Stop

Variable Trailing Stop

Fixed Trailing Stop

Variable Trailing Stop

Fixed Trailing Stop

-10

11.6%

11.6%

38.5%

38.5%

31.4%

31.4%

7.9%

7.9%

-15

35.2%

35.2%

38.5%

38.5%

27.0%

27.0%

1.5%

2.4%

-20

40.7%

39.1%

47.6%

39.2%

32.7%

32.7%

-0.4%

0.4%

-25

40.7%

40.7%

47.6%

47.6%

32.7%

30.9%

1.1%

-0.7%

-30

40.7%

40.7%

47.6%

47.6%

37.8%

36.0%

3.2%

1.3%

-35

40.7%

40.7%

47.6%

47.6%

37.8%

36.0%

2.8%

2.8%

-40

40.7%

40.7%

47.6%

47.6%

32.4%

32.4%

6.7%

0.5%

-50

40.7%

40.7%

47.6%

47.6%

32.0%

32.0%

7.1%

7.1%

-60

40.7%

40.7%

47.6%

47.6%

32.0%

32.0%

7.1%

7.1%

-70

40.7%

40.7%

47.6%

47.6%

32.0%

32.0%

7.1%

7.1%

-80

40.7%

40.7%

47.6%

47.6%

32.0%

32.0%

7.1%

7.1%

-90

40.7%

40.7%

85.0%

85.0%

32.0%

32.0%

7.1%

7.1%

-100

40.7%

40.7%

85.0%

85.0%

32.0%

32.0%

7.1%

7.1%

 

 

 

      Applying trailing stops to individual stocks is most easily done by putting the data and formulas in an Excel spreadsheet.  XLQPlus can then be used to retrieve stock prices automatically from Yahoo and MSN.  The spreadsheet then dynamically calculates stop loss settings and when it is time to buy, hold or sell.  An automated spreadsheet named “Portfolio Tracking” that does this is now available as a free download at http://www.wisertrader.com/excel.php . 

 

 

 

2.0 Market Analysis

 

      Fear in the markets has temporarily subsided.  An inability of the Fed to pause its tightening stance should lead the S&P 500 to migrate lower to its long-term support level below 1,240 before it resumes a sustained rally. 

 

      Key industry ETF’s in Table 2A are Biotech and Semiconductors, which confirm the NASDAQ.  Transportation confirms the Dow Jones Industrial Average according to Dow Theory.  Banking and Financials are confirming indicators for the S&P 500.  Gold and Housing are respective indicators for the inverse health of the currency (inflation) and the capacity for consumer spending. 

 

 

Table 2A

Indices, Key Industry ETF’s and Sector SPDR’s

 

1 month

1 wk ago

2 wks ago

3 wks ago

4 wks ago

Dow Jones Industrial Index

-2.8%

-0.3%

1.2%

-2.1%

-1.7%

NASDAQ Composite Index

-5.3%

0.4%

0.8%

-2.2%

-4.2%

S & P 500 Index

-2.8%

0.6%

1.0%

-1.9%

-2.6%

NYSE Composite Index

-3.8%

0.8%

0.8%

-2.8%

-2.6%

Russell 2000 Index

-5.7%

1.1%

1.0%

-2.7%

-5.0%

HGX, Phil. Housing Index

-10.9%

-1.9%

0.1%

-4.4%

-5.1%

IYR, Real Estate

-0.9%

2.2%

1.7%

-1.5%

-3.2%

GLD, GOLD

-6.6%

-2.5%

-0.7%

-7.8%

4.6%

RKH, Banking

-3.3%

1.4%

0.7%

-1.9%

-3.4%

IYT, Transportation

-3.8%

1.8%

1.1%

-4.2%

-2.4%

SMH, Semiconductors

-9.0%

1.2%

-2.8%

-2.1%

-5.6%

BBH, Biotechnology

1.7%

0.9%

2.3%

0.4%

-1.9%

OIH, Oil Infrastructure

-5.9%

3.5%

2.9%

-7.4%

-4.6%

XLE, Energy

-4.0%

2.6%

2.0%

-4.8%

-3.6%

XLU, Utilities

1.1%

2.9%

1.7%

-0.5%

-2.9%

XLB, Materials

-5.3%

0.8%

1.0%

-4.6%

-2.5%

XLI, Industrial

-3.8%