They’re talking about the series of calculations that are used to determine the value of options. The calculations are designated by various letters of the Greek alphabet, from which they get their name.

On our agenda today is delta.

Best known as the fourth letter of the Greek alphabet (or seen in movies followed by the word “Force”), delta represents change. In options, that means the rate of change in the value of an option as related to the underlying instrument.

I know that seems like a mouthful, and it is, but bear with me and it’ll make a lot of sense shortly. (Plus you’ll sound like a genius among your friends.)

Every option, whether call or put, has a delta attached to it. Generally you can find this information on your broker’s Web site.

A call has a positive delta, and a put has a negative one.

If an option is at the money, usually the call option will be a delta of +.50 and the put option will be -.50.

Thus, if the GBP/USD is currently trading at 1.6400, the 1.64 call option has a delta of +.50 and the 1.64 August put option has a delta of -.50.

As the pair moves up in value (that is, the sterling appreciates against the dollar), the sterling calls will increase in value. As of this writing, they are trading at $2.51 x $2.63. With the delta at +.50, that tells us that for every penny the sterling increases in value (which would be measured as 100 pips), the option will increase 50 cents. Thus the delta is the measure of the rate of change in the value of the option as compared to the value of the underlying asset.

The reverse is also true. If the spot price fell 1 cent, or 100 pips, the value of the put option would increase by 50 cents.
We also have another inverse relationship to consider. If we are holding put options and the spot price increased, the value of the put option would FALL by 50 cents. Same is true of the call. A 100-pip or 1-cent decrease in the underlying spot price would make the option fall by 50 cents.

So if the pound is at 1.6400, and we are looking at the August 1.64 calls, let’s say we go ahead and we buy them right now at $2.63 ($263). We believe the sterling is going to rise and the options are going up in value. If the spot price goes to 1.6500, we can expect the call option to move up 50 cents in value to $3.01 x $3.13, giving us a return of 38 cents per position.

However, at that level, the delta has changed (actually it always changes as the price changes, but for the sake of simplicity we won’t go into that detail). At this point the delta is nearly +.60. So now for every cent the spot moves up, our option will increase by 60 cents. By the time that the call option is deep in the money, it will have a delta of 1.00. That means that for every 100 pips, or 1-cent move, in the spot, the option will move a corresponding 100 cents. The same is true for a deep in-the-money put. It will eventually reach its maximum delta of -1.00, at which point it will move in lockstep with the spot price.

How does this help us? Mainly in terms of entries and exits that we would like to plan in advance.

Planning Moves with Delta

Let’s go back to our British pound calls. When we last left them, we were at the purchase price of $2.63 ($263). We know that for the price to break even, we must see the underlying spot price move to 1.6663 by expiration. If it moves up, but less than $2.63, our position will be worth something, but it will still be a loss.

If we want our position to double, we can use delta to make the following calculation. A 1-cent move will increase our value by 50 cents to $3.13. Another 1-cent or 100-pip move will increase our option value by 60 cents to 3.73. That increases our delta to .65. Another 1-cent or 100-pip move will take us to $4.38.

That takes our spot to 1.6700. It is now 3 cents (or 300 pips) above our strike price and is valued with an additional $1.38 in time value to make up the whole price of $4.38.

If it never moves another pip or penny until expiration (where time value is zero), we would still have a 37 cent profit on the option – that’s simply taking the 3-cent or 300-pip move on the underlying spot and subtracting out our original $2.63 entry price.

But back to our example, we still have some time value and we are aiming for a double. Thus we need the option price to end at $5.26 ($526) or higher. At this point, our delta has reached +.70. Thus another 1-cent, 100-pip, move adds 70 cents to our $4.38 to make it $5.08. We are now only 18 cents shy of our target, and our delta has now risen to +.78, so we only need a move of 23 pips to get us to our target.

We have viewed a move of 423 pips (or approximately 4.25 cents) to produce it. But that isn’t all that goes into the equation. Time value has also deteriorated during this process and added some volatility.

Nevertheless, we can use delta to estimate our profit targets and keep them in line with current underlying movements of the market.

Hope that clears up some of the mystery about these Greek terms you hear tossed around.

Until next time,
Bill Jenkins

August 3, 2009

Make Profitable Market Moves Using “Options Greeks” was originally featured in the Penny Sleuth.

While most investors have kept their eyes glued to American markets over the course of the recession of 2008 and 2009, Japan has been host to its own set of economic problems. And as more eyes turn to the Japanese economy, a potentially profitable ETF play is emerging right before us.

Here’s how you could benefit from Japan’s deflationary woes…

Boom, Bubble, and Bust

More than twenty years ago, Japan was experiencing an economic boom unlike anything seen in a generation. The Japanese car industry was gearing up as a serious competitor to the big three American automakers, and Japan’s tech sector was beginning to find its legs. Ever-climbing Japanese stocks became hugely popular in the financial world, and real estate in Japan rocketed along with them.

By 1989, property prices in Tokyo’s most desirable neighborhoods reached as high as $93,000 per square foot, making it the most expensive city in the world. But that prosperity wasn’t to be long-lived.

Over the course of three days in 1990, Japan’s asset price bubble burst, and the Tokyo Stock Exchange lost $400 billion in value. But that was just the tip of the iceberg. Over the course of the next 14 years, the Japanese economy continued its fall and subsequent stagnation – a period of time known simply as “the lost decade”.

Japan’s problem wasn’t unfamiliar. In the years after World War II, Japan’s fast-growing economy became a hotspot for stock market and real estate speculation fueled by high-risk, subprime debt. When the asset price bubble popped, it caused a chain reaction that put the Japanese economy at a standstill.

In 2007, Japan looked like it was finally regaining economic ground as real estate prices rose for the first time since 1990… then the subprime mortgage crisis happened here in the United States, throwing economies across the world into a tailspin.

Ironically, it was almost the exact same circumstances that lead to Japan’s asset price bubble that ushered in the recession we’re facing today.

Does Deflation Spell Doom for Japan?

But the economic problems facing Japan and the United States are far from the same. That’s because while the U.S. has maintained a moderate rate of inflation for the duration of the recession, Japan is currently on a crash course for deflation.

In essence, strong deflation is the equivalent of pulling the handbrake on the economy.

Unlike inflation, where the buying power of a dollar decreases over time (the reason you can’t buy a McDonald’s hamburger for 15 cents anymore), deflation causes the buying power of money to increase. And while that might sound attractive, the economic consequences of deflation far exceed the benefits.

That’s a serious concern according to Fed Chairman Ben Bernanke and his league of economists. “Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero,” explained Bernanke to Washington D.C.’s National Economists Club back in 2002.

“Once the nominal interest rate is at zero,” he continued,  “…no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash.”

When holding onto cash is more lucrative for lenders than making loans, credit markets seize, and economic activity screeches to a halt. Deflation also means that current debts – like a $300 car payment – become comparatively huge amounts of money to dole out.

“Profits fall, then wages come down, then consumers stop shopping,” Junko Nishioka, chief Japan economist at RBS Securities Japan told Bloomberg. “And because people aren’t shopping, companies lower prices. That’s the process that we’re starting to see. It isn’t easy to break out of.”

Ben Bernanke and the powers that be have made it clear that they’ll do whatever it takes to avoid deflation right now here in the U.S… But that’s not what’s going on in Japan.

The inflation (or deflation) rate is measured by the Consumer Price Index – an index that measures the prices of a basket of consumer goods. As the CPI drops the risk of deflation rises substantially. In May Japan’s main index of consumer prices dropped 1.1%, the biggest decline since 2002. That marks the fifth straight month of price decreases in Japan.

Land of the Rising Yen

Through all of this, the biggest winner has been Japan’s currency, the yen. As deflationary pressures rise, giving each yen more buying power, the currency’s value relative to other countries’ money rises as well.

Since last August, the yen has gained 17.9% against the U.S. dollar and nearly 30% against the Euro, making it one of the most attractive and powerful currencies right now for Forex traders.

That deflation-driven bull market in the Japanese yen has made for an interesting ETF play as well. At present, there are a number of ETFs and ETNs that trade in concert with the ebbs and flows of the yen. Some of the more popular funds include the CurrencyShares Japanese Yen Trust (NYSE: FXY), iPath USD/JPY Exchange Rate ETN (NYSE: JYN), and WisdomTree Dreyfus Japanese Yen Fund (NYSE: JYF).

While each of these funds has a somewhat different investment objective, FXY is the most heavily traded by far, and most liquid.

As you can see from the chart above, FXY’s price action hasn’t been calm and steady, but it has followed an overall uptrend over the course of the last year. After a double top in January, the fund’s price retraced around half of its previous rally before pushing back up. That’s a good sign that suggests shares of the ETF are set to break or at least match the previous high.

Surging volume on upward price movements confirms that investors see the yen pushing up.

FXY looks like it could be finding support on at its 200-day moving average on a pullback. If that happens, it’s time to think about going long on the yen.

While it’s very likely that the Japanese government will step in and attempt to curb deflation before it starts in earnest, their actions won’t be felt until much later in the game. Currencies are very susceptible to politics and world changes, so keep a tight stop on this ETF if you’re considering a short-term trade.

Cheers,
Jonas Elmerraji

July 15, 2009

Profit from Japan’s Deflationary Woes was originally featured in the Penny Sleuth.

But some things provide “reasonable markers” to see what a currency is doing. One of my “favorites,” although I hate to call it that, is the “civil unrest factor.”

Across the Eurozone escalating economic problems and disagreements between members and neighbors have touched off riots and outbreaks of violence. People involved in civil unrest are a multifold problem. First, they have too much time on their hands because they are not working. Jobless citizens, especially in a heavily socialist culture, are a continual drag on the system. Second, it costs money to keep repressing social upheaval — presenting another drag on the system. Additionally, the passions and fears of men being what they are, such activities tend to draw in more normally productive folks as the snowball gains speed and volume.

Here in the United States, we are not facing such difficulties (yet). This means a more reasonable system of work and distribution of goods and labor. All in all, this is good for a culture, the body politic and the economy. As a result, it also breeds greater confidence in the currency. And when all is said and done, investment money will go where there is a reasonable likelihood of return, even if the return may be lower.

Specifically, there are several exotic currencies that have offered high rates of return for speculative investors and traders, like the Brazilian real and the Indian rupee, just to name two. But it is difficult to place large sums of money there simply for the sake of the wild swings in value. A high interest rate is no good if the principle of the investment is destroyed by currency depreciation.

This is what has been good up to this point in the recession/depression for the U.S. dollar. And if this continues to unfold over the next year or two in similar fashion, this would still produce U.S. dollar strength compared to the euro simply by the “fear factor.”

Now let’s end with a look at my favorite currency, the Australian dollar.

The Aussie dollar chart looks remarkably like the euro — going back to the beginning of June. All things considered, that’s rather remarkable given the relative strength of the Aussie economy compared to the Eurozone. Nevertheless, fundamentals will eventually rule the day, and though we may have to wait it out a bit, we look for the Aussie to rebound in the future.

One of the difficult parts of the equation at this point is the widely reported and detrimental riots in China’s western Urumqi (pronuonced U-rum-CHEE) province. Ethnic fighting between Muslims and Chinese citizens has threatened to overpower the police force.

As you know, Australia’s success going forward is inextricably tied to China. So worries about riots in one part of the country can certainly be detrimental in other parts as well. Even though the violence in other provinces may not be ethnically related, once a group of people feel they have been wronged and have the sheer numbers to overpower a military or police crackdown, all heck can break loose.

Remember, there is significant fear of unrest all over China as the depression sets in. The people were just getting their first dose of “la dolce vida,” only to have it stripped away. And gone are the days when they trusted their government to provide for them. Now it is beginning to look more like the enemy than a loving “big brother.”

For now, though, the Aussie dollar hasn’t been impacted by the fray. It has been well supported at the 78.25 level. A strong close below 78 on the daily chart would invalidate that forecast, and likely lead to more downside. We’ll just keep our eyes open.

Until next time…Happy Trading!
Bill

July 14, 2009

Why the Aussie Dollar Is My Favorite Currency was originally featured in the Penny Sleuth.

‘Tis all rather foreboding…

Of course, if you’re a government statistician, you probably have a different view of things — especially after the recent numbers oozing out of Washington.

The last time we sailed to together, I predicted the personal savings rate was headed to 5%. Low and behold, we learned this week that it has risen to 5.7%! Looks like I have ESP. I’m thinking about starting one of those 1-900 telephone numbers! (Are they even still around?)

Then on Friday came the job(less) report from the Bureau of Labor Statistics. A lot of people cheered… but only the ones who took the numbers at face value.

The data said that the United States only lost 345,000 jobs. That’s still breathtaking, but after the nearly three-quarters of a million lost just a few months ago, it looks like real improvement.

But you may recall me talking about the mysterious “ghost jobs” that just magically appeared in the last report. Not actual people — just people the government assumes must be working. Well, they’re back to it again! In May they “created” 220,000 jobs (20% of which were supposedly in CONSTRUCTION!). Oh, come on, really?

The backside of the number is not much more encouraging — 3.9 million long-term unemployed (those unemployed for more than six months). The long-term unemployed figures are what will really come home to roost. All these people, on a government-mandated insurance program, surely create an additional drain and add nothing to GDP.

Also, we must not forget those who have “dropped off the radar.” The folks unemployed for so long, they’ve quit looking, quit drawing benefits, and quit trusting in the “Hope” and “Change We Can Believe In.” The total number of unemployed now stands at 14.5 million Americans. Lord have mercy…

Now let’s try this on for size. Remember all the feel-good consumer sentiment indexes that have been rising? Remember how I told you to be wary of them? Let’s take a peek behind another curtain for a clearer view.

Last September, Americans added $6.98 billion in debt to household balance sheets. The three-month moving average for consumer credit was $3.436 billion in August 2008 and fell to $2.886 billion in September. At that point, the terror was coming into its heyday, and it seemed like the world would end and the sun was about to burn out. Americans began their own personal contraction — a spending contraction. They took whatever available cash they had and put it against the tons of available credit balances. In March and April of this year, we collectively paid down $32.2 billion in debt. The three-month moving average for April was -$14.366 billion.

On top of that, as mentioned, Americans have been saving more, too. In fact, the savings rate is at a 14-year high.

Frankly, I suppose that people are feeling better because they have paid down some debt and have a bit more cash tucked away. But either way, they are not contributing to further consumerism.

As for the greenback itself, the U.S. dollar index is now fighting with the 80 level. It has broken below, moved a above and is now heading lower again.

Sincerely,
Bill Jenkins

June 11, 2009

GM Bites the Bullet… Will the Dollar Follow? was originally featured in the Penny Sleuth.

Consider the Treasury International Capital (TIC) flow data. TIC measures foreign investment in the United States. This is important because we rely on foreign investors and sovereign governments to continue funding our deficit spending.

But the most recent numbers show a major decrease — $23.2 billion in March, versus an outflow of $91.1 billion the previous month. That will put Ben Bernanke and his boys in an even tougher spot.

Here’s our pal Chuck Butler from EverBank weighing in on this. “There are two ways they can try to entice these foreign investors back into the U.S. Treasury market. They can either let interest rates increase, or let the value of the U.S. dollar fall.

Now which do you think they will choose? They have been running the printing presses on overdrive in order to try and keep interest rates down to create another refinance boom. That tells me the Fed will try to do everything they can to keep interest rates down, so their only option is to let the U.S. dollar fall.”

The drop in TIC flows, combined with a huge increase in funding requirements by the United States, will have to lead to a general debasing of the U.S. dollar.

That’s not to say things are better on the other side of the Atlantic. The Eurozone (EZ) unveiled some nasty economic news last week.

Let’s start with the real engine of the EZ, Germany. Its first-quarter 2009 GDP number showed a contraction of 3.8%, worse than forecast, and the worst figure since 1970, when these records began. Annually, they are looking at a 6.7% contraction, another record.

In the last nine months, Germany has squandered all of its GDP gains accrued since 2005.

Right on their heels, the EZ composite stats showed a 2.5% GDP drop for the quarter. Again, annualized, that comes in at a 4.6% drop… both of these numbers are records, too.

Expanding our horizons just a bit, we see that Spain continues adding fuel to the fire. Even though Standard & Poor’s has already cut the country’s credit rating, the Spanish folks unveiled their worst recession in four decades. GDP shrank 1.8%, after a 1% drop in the last reading. A year ago, GDP was 2.9% higher. It isn’t a record number, but you’d have to go back 40 years to find something similar.

How much further can Spain fall (and Ireland, and Greece as well) before the euro enters crisis mode?

The truth is, we’ve never been down a road quite like this one. So the map we have is out of date. But there is one thing it can tell us — there is a cliff and a gorge ahead. We just can’t tell how far away it is, or around which bend we’ll find it. No matter, we’ll keep the pedal to the metal, so at least we can make good time getting there…

Adding to the loud accelerating noise in the Eurozone this week, Reuters reports that the European Central Bank (ECB) “has rejected several Central European central banks’ request to accept local currency bonds as collateral,” according to Hungarian central bank’s Kiraly.

Remember that the ECB adopted quantitative easing (QE) — buying bonds — some weeks ago, but there was a significant dissenting vote. Germany’s central bank, the Bundesbank, the most influential in the ECB, was completely against QE.

Axel Weber, the Bundesbank’s president, said, “the ECB has done enough to help the economy and shouldn’t consider further measures unless things get a lot worse.” He added, “The ECB doesn’t see the risk of a broad credit crunch or deflation in the euro area.”

I’m pretty sure his counterparts in Spain, Ireland and Greece will take umbrage at his position.

As I’ve written before, the bureaucracy in the EZ makes these decisions and policies tough to carry out. ECB President Jean-Claude Trichet is going to have to work out some kind of ceasefire between the factions. Which means they still have no concrete plan to stimulate anything other than infighting. While this is happening, the euro is speeding closer and closer to the cliff.

Sincerely,
Bill Jenkins

May 20, 2009

FOREX Update: The Dollar and the Importance of TIC Flows was originally featured in the Penny Sleuth.