Two fingers of twenty five

Vol #218

It’s useful to keep a measuring stick on you at all times.

Fortunately, whether it’s your fingers, feet, or arms length, we’re all walking benchmarks. Ten paces is a good distance to know, high noon or no duel.

But my size is not your size, so we need a standard twelve inch foot. A stride becomes something like a yard or meter. I can’t measure a new stud wall with my fingers, but it’s a damn good way to pour bourbon.

Booker Noe reigned as Jim Beam’s Master Distiller for over forty years, carrying on his grandfather’s tradition and ushering in the now popular concept of small batch productions. Standing at six feet four inches tall, he was famous for saying “a respectable amount of bourbon to pour in a glass is about two fingers. Lucky for me, I've got big fingers.”

Two fingers is a hefty serving, no matter what the size of your digits or glassware is. It’s more than enough to get a conversation started, and carry you well past the pleasantries.

Pouring a tipple in the study after dinner, that’s all the measurement you need. Fingers scale to your size and weight, very roughly providing a proxy for how much alcohol you can metabolize. Not only are they always with you, these ten little rulers tell something about their user.

Even if our individual benchmarks vary, the ruler is the same no matter what’s in the glass. Booker’s Rye is not Jim Beam - 136 proof versus the flagship bourbon at only 80. The same two fingers, but a wildly different ride.

It’s the same thing with a twenty five delta option - they will hit completely differently depending on the underlying curve. A one quarter chance of movement isn’t the same with Gamestop or Bitcoin in your glass.

Starting with the basics, delta is the options price sensitivity to changes in underlying price. It also approximates the chances of that option finishing in the money, and is used as a hedge ratio. 25 delta (.25) gets hedged with 25 shares of stock, a quarter of the 100 share multiplier.

But it’s first and foremost a sensitivity derived from the options pricing model. Delta is highly dependent on the inputs to the model - volatility, stock price, and interest rates. This makes comparing volatility pricing at a fixed delta over time and between stocks instructive. What you’re tasting changes, but an important variable is fixed.

Every delta paints a bit of the skew curve picture. The absolute height and relative shape define the market's expectations of where price is likely to go. But if we boil it down to the essentials, besides at-the-money, twenty five is a good place to start. (Same with bourbons, if you can afford it.)

Wings take off about here. As delta drops on either the call or put side, beyond this one in four chance, probabilities descend into the wild randomness of tails and nickel lotteries.

The relative price of these options is the rough sketch of the slope of skew, adding the ATM option creates the inklings of a smile or frown. Pricing the risk reversal (named because it would invert the directional risk of a long or short stock position) is selling the call and buying the put (or vice versa). That spread in vol points is interesting measured independently as well as a proportion of the ATM vol level.

Because we are using delta (and not dollars, or even percent) as our benchmark, these comparisons are richer. 10% out of the money means a very different thing in Nvidia than SPX. But twenty five delta is always a twenty five percent chance - whether that's $5 or $50 away.

The OCC has a great calculator to play around with the model and see how greeks behave. Today in yellow, thirty days out, the 25 delta option is struck at $5860 in SPX vs spot at $5587 - 4.9% out of the money. If we adjust that 21.9% implied vol down to what it was a month ago, the 25 delta option was only a 9.8% vol. Applying history to today in red, we get closer to the $5710 strike as 25 delta, $150 dollars and 2.7 percentage points closer.

The same applies for a comparison between two names. AAPL only lists in $5 intervals, but the same month ago there was one at almost exactly 25 delta, $255 vs. $244.18 spot, with a 20.1% implied volatility. Today, the implied volatility of the 22 delta option at thirty days is 30.1%.

AAPL IV at the 25 delta level has moved up, but it is not quite as reactive as the SPX volatility change - 12.1 points. That’s even with the SPX down 8.8%, and AAPL down 12%. A good portion of the move was already priced in at the starting 20% IV of AAPL, so there is less adjusting to do.

With the helpful measuring stick of 25 delta, we can move back and forth in time and across different issues. This adaptability is very useful as an indicator, but that situational awareness only extends so far.

If you always look to sell a call based on its delta, the distance and premium will change. That’s good in that you sell further out when implied volatility is high, but you’re still selling implied volatility at the prevailing level. We’ve seen in many dimensions just how well the market prices movement.

The above pricing in SPX offers you today twice the premium ($51.70) for more than twice the upside than you got a month ago. That says absolutely nothing about whether it’s a good trade or bad trade. The chances of settling over the call strike are identical.

This is important for covered call writers. If you want to collect premiums, understand that a) the market pays more when it thinks it will move more, and b) that implied volatility extends to the downside risk too.

When the time is right, the 25 delta is a great target. But not every market is for drinking bourbon. An options trader has to be more selective.

Sizing up a strip of options with your trusty twenty five delta options spread tells you a lot about what the market is feeling. With two fingers and a hammer, you can tell a lot.