Using Options Charm To Help Select Strikes
Using Options Charm To Help Select Strikes
Out-of-the-money (OTM) strikes with stronger charms lead to faster delta decay
- A basic understanding of second-order greeks, such as option charm, can help with both strategy selection and strike selection.
- While ATM strikes have weaker charms, OTM and ITM strikes have stronger charms.
- Knowing OTM strikes with stronger charms will lead to faster delta decays could give an edge to pushing your strikes even further OTM on your short premium strategies.
Day-to-day, we use primarily the first-order greeks in our analysis. Specifically, options delta and options theta are key metrics we monitor almost continuously. By focusing on delta, we’re able to gauge the directional bias of our individual positions or in our overall portfolio. By focusing on theta, we measure how much time decay we have working for us and how valuable the passage of time will be toward achieving our objectives.
Going deeper, however, some second-order greeks, like options charm, can also assist in our analysis, even if we don’t use them as practically as we might a delta or theta. Just having an elementary understanding of charm can help with both strategy selection and strike selection.
Options charm: What it is
While delta measures how an option’s price changes when the underlying stock price changes, and theta measures how an option’s price will change when time passes, charm essentially mixes these two variables. As a second derivative of the Black-Scholes options pricing model, charm takes the derivative of the model with respect to price first and then with respect to time second. So, charm shows how quickly or slowly delta itself is changing over time.
Options that are at-the-money (ATM) have weaker charms, or their deltas change less with the passage of time. Options that are out-of-the-money (OTM) or in-the-money (ITM) have stronger charms, or their deltas change more with the passage of time. Naturally, an OTM option’s delta will move closer to zero as time passes, and an ITM option’s delta will move closer to 1 or -1 (depending on what type of option it is) as time passes, and all other things being equal.
Options charm: Why it matters
Just understanding these basic elements of charm can help significantly with both strategy selection and strike selection. For instance, we know it’s effective to sell OTM premium in the form of a short strangle, short put or put ratio spread because of its positive theta and high probability of profit. But now we also know these strategies benefit greatly from the charm effect pushing the strategy’s delta closer to zero with each passing day.
Furthermore, within these strategies, we know that with strike selection there is a tradeoff between credit collected and probability of profit. The further OTM we place our strikes, the higher our probabilities but the lower our credits. However, if we choose strikes that are less OTM, then we can collect more credit, at the expense of lower probabilities.
By adding charm to the mix, we might now give an edge to the further OTM strikes because their deltas decay more rapidly. This accelerated deterioration will naturally drag down extrinsic values more quickly, enabling you to reach your profit targets faster.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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