Option delta is probably the first option greek many option traders learn. When I first heard and learned about the power of options, I was intrigued. Instead of buying shares of stock I could purchase a call for far less money and profit if my outlook is correct? Sign me up! There are other greeks that can affect an option position, but delta is pivotal. Let’s take a look below.
What Is Option Delta?
The explanation I like best is that delta is the rate of change of an option based on the underlying. To keep it simple, for every $1 the underlying moves, the option premium should change by the amount of delta. Essentially there are only four things you can do with options: buy a call, sell a call, buy a put or sell a put. Long calls and short puts have positive deltas and can benefit from a move higher in the underlying. Short calls and long puts have negative deltas and can benefit from a move lower in the underlying. A long call with a positive delta of 0.40 should increase about 0.40 ($40 in real terms) if the underlying moved a dollar higher and vice versa.
Another definition of option delta that many investors will use is the percentage of the option expiring in-the-money (ITM). So, if the option delta is 0.20, you might say that at expiration, the option has an 80% (100 – 20) chance of expiring out-of-the-money (OTM) or worthless. Investors who often sell options will use this as a guide of probability. Some will also say that option delta is having the equivalent number of shares of stock. If a position has a positive 0.60 delta and the stock moves a dollar higher, the option should gain about 0.60 ($60 in real terms). This is like owning 60 shares of stock with that same move of a dollar higher.
Benefits of Option Delta
As mentioned above, options can be significantly cheaper than buying the underlying outright. By using option delta as your guide, you can gauge your expected profit or loss based on the size of your delta, which you can determine. This is done by buying or selling different strikes and different contract sizes as well. Of course, the bigger the desired delta the bigger the risk. But it will still be significantly less than, say, owning shares of stock. Does this mean that playing the delta is a foolproof way to analyze an option? No. There are other important pricing factors that affect the value of an option. Time (theta), volatility (vega) and more also play important roles. Delta is just one of the greeks traders should take into account when looking for the right option to purchase.
Option Delta Example
Let’s say you have a bearish bias on a stock and you think it will move lower over the next couple of weeks. With the stock trading just above $58 a share, the option trader decides he does not want to risk more than $250 on his position. Looking at the option chart below, he decides to buy the 55-strike put with 37 days to go to expiration.
Since the option position is a long put, the delta is a negative 0.34 (rounded up from 0.3376). So, what does that mean? If the stock moves a dollar lower based on current delta solely, the option premium should increase by about 0.34 ($34 in real terms). The option trader has a negative delta and a negative move in the stock, which would increase the put premium. If the stock moved $2 higher, the put option would lose a value of 0.68 (2 X 0.34) ($68 in real terms) based on delta alone. This is a simplistic but fairly accurate example of what to expect based on delta and the movement of the stock.
There is so much more to understanding option delta and options in general than these few points and examples. But understanding and applying them can help your option trading immensely. Delta is just one of the greeks that can affect your option position, but for some trades it can be the most important.
Senior Options Instructor
Market Taker Mentoring, Inc.