Delta −0.34
Gamma−0.15
Theta 0.02
Vega −0.07
The short call has a negative delta. It also has negative gamma and vega,
but it has positive time decay (theta). As Johnson & Johnson ticks higher,
the delta increases the nominal value of the call. Although this is not a
directional trade per se, delta is a crucial element. It will have a big impact
on Brendan’s expectations as to how high the stock can rise before he must
take his loss.
First, Brendan considers how much the option price can move before he
covers. The market now is 0.66 bid at 0.68 offer. To buy back his calls at
1.10, they must be offered at 1.10. The difference between the offer now
and the offer price at which Brendan will cover is 0.42 (that’s 1.10 − 0.68).
Brendan can use delta to convert the change in the ask prices into a stock
price change. To do so, Brendan divides the change in the option price by
the delta.
The −0.34 delta indicates that if JNJ rises $1.24, the calls should be
offered at 1.10.
Brendan takes note that the bid-ask spreads are typically 0.01 to 0.03
wide in near-term Johnson & Johnson options trading under 1.00. This is
not necessarily the case in other option classes. Less liquid names have
wider spreads. If the spreads were wider, Brendan would have more
slippage. Slippage is the difference between the assumed trade price and the
actual price of the fill as a product of the bid-ask spread. It’s the difference
between theory and reality. If the bid-ask spread had a typical width of, say,
0.70, the market would be something more like 0.40 bid at 1.10 offer. In
this case, if the stock moved even a few cents higher, Brendan could not
buy his calls back at his targeted exit price of 1.10. The tighter markets
provide lower transaction costs in the form of lower slippage. Therefore,
there is more leeway if the stock moves adversely when there are tighter
bid-ask option spreads.