When I start one-on-one coaching sessions with option traders, I ask them their definition of delta. I get a range of responses from most of them, somewhere in the neighborhood of the rate of change of the option premium. Understanding all the option greeks is pretty much mandatory to truly knowing how options function. For option traders, both new and experienced, knowing what option delta is and what it means for your option position is a key component of a profitable trade. Let’s look at the four main definitions of option delta.
Delta Is…
- The rate of change of an option value relative to a change in the underlying price
- The derivative of the graph of an option value in relation to the stock price
- The equivalent of underlying shares represented by an option position
- The estimate of the likelihood of an option expiring in-the-money (ITM)
Delta in a Different Light
Long calls and short puts have positive deltas and benefit from a move higher in the underlying. Short calls and long puts have negative deltas and benefit from a move lower in the underlying. A long call with a positive delta of 0.60 should increase about 0.60 ($60 in real terms) if the underlying moves a dollar higher and vice versa based on delta alone. Option gamma, theta and vega are the other greeks that will contribute in a positive or negative way to the position as well.
Definitions in Action
Investors who use options will often consider the fourth definition of delta listed above. For example, if an investor sold a put option with a positive 0.10 delta, he or she might say that the option has a 90% (100 – 0.10) likelihood of expiring out-of-the-money (OTM) or worthless. Other investors and traders who frequently use options will consider the current delta as the equivalent number of shares of stock. For example, if a position has a negative 0.40 delta and the stock moves a dollar lower, the option should gain about 0.40 ($40 in real terms). This is like shorting (or selling short) 40 shares of stock with that same move of a dollar lower.
Delta Benefits
In my opinion, too many option traders focus only on selling options and premium. Buyers of options know that using options can significantly reduce their outlay versus long or short stock positions. 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.
Almost everything about options is a trade-off. The bigger the desired delta, the bigger the risk many times. If risk is not increased, other option greeks like theta are usually affected. Either way, buying options will still be significantly less than owning shares of stock. Delta is certainly not a fool-proof way to analyze an option or the only way, but it can be really valuable and much more so than option traders might understand.
Final Thoughts
Learning, understanding and experiencing how delta functions can be pivotal for your success as an option trader. Option delta is straightforward, but there are several intricate nuances involved. Gaining valuable experience either through trading and/or studying screenshots of various option chains may be the best teacher of them all. Trust me, it has helped me immensely.
John Kmiecik
Senior Options Instructor
Market Taker Mentoring
