How to trade Stock Options using Data Science and AI techniques — Making Passive Income Part 3 (DELTA and Peer Valuation Analysis) ( Final Part)
Welcome to part 3 and final part of our Making passive income using Data science and AI Techniques , congratulation if you made it this far . Let me refresh you memory and give you a quick summary on what I’ve published earlier on this subject. Making money from options is not an easy feat , however with my steps you can simply get the fundamental information needed to invest safely leveraging Data science and Ai Tools .
We talked about what is Open interest & total Volume of stock options and how can you use the information arise from it to your advantage and pinpoint the best liquid stocks out there , we also talked about the volatility of stock options and how important is volatility to select the more suitable stock of which that align with our investment objective.
On out third part I will explain how to come up with Stock options prices ( DELTA) , also I will explain how can you create a simple fundamental table of all important multiple for a give list of stocks that will help you on your stock option selection.
Before we talk about Delta , We need to understand where it came from. Delta is one of many risk measurement indicator of Stock Options trading . There are various risk measures for options, We call them “ The Greeks”, as they all represented by a Greek letter or a character, and they are:
· Delta : Which we will talk about it in details in this article.
· Gamma : Gamma is an options risk metric that measure the rate of change for an option’s delta based on a single-point move in the delta’s price, simply put the higher the Gamma value the more volatile the option price is .
· Theta : When you think of theta , think of time decay. Theta is a risk measurement that measure the rate of decline in the value of an option over time, This means an option loses value as time moves closer to its maturity, depends on the type of trades you placed.
· Vega : Do you remember how we calculated the stock volatility of which that will play a big role in our stock option selection , Vega is another measurement of risk for option’s price sensitivity to changes in the volatility of the underlying asset. Vega represents the amount that an option contract’s price changes in reaction to a 1% change in the implied volatility of the underlying asset.
All of these Greeks measurement of risk are an important items to look at and consider , However we will talk mainly about Delta as it relates to actual and combined position, known as position delta, which is a very important concept for Contracts conceding selling puts or calls. So without further ado.
What is Delta
Delta is one of the most important Greeks of risk measurement of stock options for its involvement in taking stock options. Delta measures the sensitivity of an option’s price to movement in the underlying stock. Specifically, delta designates the amount an option’s price is expected to move based on a $1 change in the underlying security.
Delta or sometimes referred to as a hedge ratio, is important variable because it helps investors determine how option prices are likely to change as the underlying stock price changes.
Usually the calculation of delta is done in real-time by computer algorithms that continuously publish delta values to the investors or market participants. The delta value then used to assess and formulate stock option strategies to fund managers, investors, and brokers.
Now that we understand that Delta measures the sensitivity of an option’s price movement in an underlying stock, We need to understand that the Delta value can be positive or negative depending on the type of stock option contract .
Delta Value for Call options
Here the Delta value of a call options always range from 0 to +1 , for the reason that there is a positive relationship between the changes in the underlying stock price and the call option price.
For example if the call stock option price is at 0.25 and the underlying stock price moved by $1 dollar , then the call option will increase by about $0.25, of course assuming essentially unchanged implied volatility and time-to-expiry.
Delta Values for Put options
On the other hand, the Delta value of a Put options always range from -1 to 0 , for the reason that there is a negative relationship between the changes in the underlying stock price and the Put option price.
For example if the Put stock option price is at 0.25 and the underlying stock price moved by $1 dollar , then the Put option will decrease by about $0.25, , of course assuming essentially unchanged implied volatility and time-to-expiry.
How Delta is Calculated
Well, most professional stock option traders and sophisticated investors use complex models similar to the Black-Scholes model, which is a mathematical equation that estimates the theoretical value of options by taking into account the impact of time and other risk factors.
The mathematical formula for Delta can be calculated by dividing the change in the value of the option by the change in the value of its underlying stock, so in simple terms it’s the change in price of option price divided by the change in price of underlying stock, as mentioned below:
Where :
NOP: the new value of the stock option
IOP: the initial value of the stock option
NUS: the new value of the underlying stock
IUS: the initial value of the underlying stock
Let’s do a quick example of the formula above , Assume ABC company stock is trading at $100 a share and you Bought a call option for $20 at a strike price of $90 . Obviously you are in the money with this trade simply because the current stock price ($100) is above the strike price of $90.
Let’s assume that the price of ABC stock went up from $100 to $110 a share, and the value of stock option rises from $20 to $25 , hence the delta of this option was:
Delta = 25–20 / 110–100 = +0.50
So the theoretical change in the stock option price given the change in the underlying value of the stock price is +0.50 , given the the 10% increase in stock price from $100 to $110 a share.
Option Delta value Uses
Delta values are used to :
- Predict option price movements
- Used as probability measure that help investors measure the expected probability that an option will end in-the-money at expiration.
It’s simple the more deeper the stock option price is in the money , the closer the delta value is to +1 , vice versa if you are selling puts or calls , the closer the delta value to Zero in case of selling puts or calls.
The bottom line of all of this is that delta is a useful tool for hedging positional risk, delta can also be thought of as the probability that an option will expire in the money.
Now let’s bring some Data Science techniques to calculate stock option Delta Value.
Data Science approach to calculate Delta Value
Simplest way to calculate Delta
Defining inputs based on Delta formula and our example , as shown in the below image:
Calculating Delta Value using Black-Scholes model :
This way of calculating the Delta value is more comprehensive and takes into account the volatility, time to expiration in years and risk free rate of the stock. I will talk about it briefly as an extra knowledge that needs to be known , however I will talk more about it in details in another article at some point.
The Black-Scholes formula can be used also to determine the probability-weighted expected return of the option.
Lets assume that we have a stock or a commodity derivative expiring in one year , its current price is 110, and you purchased call options at strike price of 100 , this Risk free rate at a time is at 0.05 .
The black Scholes model will give us a Delta value of +0.73.
Personally I like the Black-Scholes model as it takes into account many essential variables that helps in making a formal investment decision for your portfolio.
A Bonus tip on Risk free rate , in order to get the latest information on Risk Free rate, you can always visit the following link https://www.cnbc.com/quotes/US10Y , and get the US 10Y treasury bill rate as it always represents the rate of return on a risk-free investment.
Peer valuation Analysis and some Key multiples
I believe this is the most important part of this article. The ability to spot and compare public listed companies using a table of your design is very crucial.
What is peer valuation and why is it important step for asset selection
Well, peer group analysis or relative valuation analysis is simply the effort of comparing a group of companies with similar business activities or areas. For instance, Coca-Cola Co. is an American multinational corporation that falls under the beverage and drinks industry. We can compare the company’s performance and key multiples to a company with a similar business area and activity, such as PepsiCo. Coca-Cola and Pepsi are both in the beverage business; however, they have also diversified their business activities into other areas within the F&B (Food and Beverage) industry.
Key ratios multiples to look for are:
· Price/earnings (PE)
Price–earnings ratio or PE ratio is calculated by simply dividing the current stock price per share by the company’s earnings per share. The company is considered overvalued if its PE value is high , while a low PE ratio might indicate that the current stock price is low relative to earnings.
· Market cap
Market capitalization of a company is simply the current total value of all company’s equity or shares of stocks, for example if a company has a total shares of 100 and it is trading at 5 , total value of this company is 100 x 5 = 500 .
· Price to book (P/B)
Aside with PE ratio , this ratio measurement is one the most used multiple to gauge company performance, Price/book is simply comparing the current market cap to its book value , Book value per share of a company is firm’s common equity divided by its number of shares outstanding. A lower price to book suggests that the stock is undervalued
· EBITDA
Earnings before interest, taxes, depreciation & Amortization is a measure of a company’s profitability of the operating business only, thus before any effects of indebtedness, state-mandated payments, and costs required to maintain its asset base, Obviously a valued investor will be interested in seeing a steady historical EBITDA growth to call a company an interesting pick.
· Consensus Target price
All biggest financial institution and Big four such as JP Morgan , Bank of America , Morgan Stanley ,Goldman Sachs, etc. Have their analysts distribute and disseminate their views and recommendation on public listed companies in the stock market in a form of target prices and fair values , basically target prices are estimates provided by analysts of future performance of companies.
· Enterprise Value/EBITDA
Enterprise Value/EBITDA or EV by EBITDA is basically the company’s Enterprise value divided by EBITDA. EV or EV multiple is simply a ratio used to determine the value of a company. EV is similar to the market cap of the company , however it is defined by the sum of the company’s market cap, total debt minus cash & cash equivalent.
A healthy EV/EBITDA ratio for a company is less than 10. It can also indicate that a stock may be undervalued.
· Dividend Yield (DY)
The formula of dividend yield is simply dividends per share divided by the current stock price ,dividend yield shows how much a company pay out in dividends every year , these dividend or can be distributed annually, semi annually, quarterly and monthly . keep in mind a yield between 3% to 6% is considered good healthy number. DY can be an important factor in evaluating a stock’s return on investment, but it shouldn’t be the only factor to look at.
These multiples are used by fund managers to measure and determine the future and current performance of publicly listed companies. There are more multiples that could be fundamental to evaluate a company; however, I believe the list of multiples I’ve chosen is enough to give you an idea of how strong or weak a company fundamentally is at a performance level. Hence, the view of these multiples will assist you in making an informed decision to either consider the stock to be part of your stock trading list or not. Once that decision is made, the next stage obviously will be if the stock is worth opening stock options contracts on or not.
I cannot talk about and explain this valuation in this article as it needs to be explained in a stand-alone article; keep in mind that performing a valuation table for an industry is a tedious task. And as an investor, you should explore this area and start working on it. Taking that extra mile to be a successful investor is a must.
For now, let me show you what a basic peer valuation table looks like.
Peer valuation analysis
As shown in the above table , Coca cola company’s Market capitalization is at USD 263 billion , it is 13 times the size of Celsius in term of market capitalization , hence its safe to say that investing in such a company will be a lot safer than investing in Celisius , of course this is not the only factor we should look at to make an informed decision. the average PE ratio for all the names are at 49.41 times the industry , hence we can gather from this information that Coca cola and pepsi are cheaper compared to the rest with a PE multiple of 26 times and below . Celsius company is seems to expensive as it is trading at 107 times the market , the stock is over priced and the stock price is running or moving faster than its earnings. EBITDA values for Coca cola and Pepsi is above 14 billions of dollars while celsius is still at USD 260 million. In all fairness Celsius is still a new company in the energy drinks spectrum and they still have along way to grow, so I won’t hold it against them , but they need to improve their multiples .
As for target prices , most of the mentioned names are closer to their target prices between 10% to 6.6% , in layman language their stock prices are close to their fair values or intrinstic values .
Note: You can always get stock target prices from many online websites and plpatforms , for now you can obtain it from CNN forecasts (e.g. https://edition.cnn.com/markets/stocks/CELH)
Moving on to EV/EBITDA , I believe all the names have an EV/EBITDA above 10 billions , between 17 to 71 billions, hence these names are considered overvalued in a sense.
Finally, only two companies from the list pay dividends that’s Coca cola and Pepsi ,they both pay 3% and 2.8% respectively.
Lastly , you can always improve your peer table valuation by adding more ratios to the table from Profitability Ratios, or efficiency ratio or even solvency ratios such as :
- Price to sales ratio
- Gross margin
- Operating margin
- Pretax margin
- Net profit margin
- Cash flow margin
- Return on assets (ROA)
- Return on Equity
- Efficiency Ratio
I can go on and go on on many others , but make sure you read about these ratios on your own time and choose what makes sense to you overall investment objective and asset allocation strategy .
We this I can finally close this chapter on how can you make actual profit trading stock options and even can help you on selecting the optimal and fundamentally sound stock for your portfolio. Remember to do your own research always before you invest and open trades and control your outcome by investing in fundamental sound companies and not just shell companies with not visible vision strategies and future prospects. Having the ability to assume calculated risk is always better than investing blindly and lose it all. Wishing all of you the very best and invest with cautious .
Please if you have any questions or if you need to reach me , Leave me a message on : Medium or comment below, you can also take your time to view my list of research published papers at ResearchGate.
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