If you want to become a better options trader, it’s important to learn about the concept of Delta and how it affects option prices and trading strategies. There are certain concepts and variables commonly referred to as the “Greeks”, that influences the price of an option. Understanding Greeks and risk measures such as Delta will give option traders some of the necessary tools needed to effectively evaluate option positions, determine options sensitivity, minimize risks and increase profitable trades.
What is Delta?
Delta is one of the most important “Greeks” or risk measures used in the valuation of Stock Options, with the others being Gamma, Theta and Vega. In simple terms, Delta measures the rate of change in the price of an option in relation to the price of the underlying asset. It tells us how much an options price will change per $1 change in the price of an underlying asset. Before going into further details on Delta it is important to understand options.
So, what exactly are Options?
There are two types of options, call options and put options.
A Call Option is a contract giving the buyer (holder) the right but not the obligation to purchase a stock or security at a specified price (strike price) within a given time period. The holder may hold the contract until expiration and then take possession of the security, or s/he may choose to sell the contract at market price before the expiration date. Call options are normally purchased with the expectation of a price increase in the underlying asset.
If at expiry:
- The price of the underlying security is below the price at which the call option was bought, this would result in a maximum loss.
- The security price is above the options price at expiration, this would result in a profit.
A Put Option gives the buyer the right but not the obligation to sell the underlying asset at a specified price (strike price) within a predetermined time period. Investors normally buy put options with the expectation of a fall in the security price.
If at expiry:
- The stock price is below the strike price, a gain would be realised as the holder has the right to sell at the predetermined price, and the option writer will have to purchase at that price.
- For the opposite scenario a loss would be realised.
Scenario and Assumptions to explain delta.
OPT Company is offering call and put options for its shares. Now let’s assume that the call option has a Delta value of 0.25 and the put option has a Delta value of – 0.75.
If the call option has a Delta value of 0.25, then a $1 change in the stock price will result in a 25 cents increase in the price of the call option. Let’s say that OPT stock was trading at $10 when the call option was purchased for $2, then a $1.00 increase in the stock price from $10 to $11 would see an increase in the call option value to $2.25 ($2.00 + $0.25).
On the other hand, if the put option in OPT shares has a delta value of -0.75 then a $1 increase in the stock price to $11 would see a decrease in the put option from $2.00 to $1.25.
Delta can either be positive or negative with call options ranging from 0 to 1 and put options ranging from -1 to 0.
- With a 0.5/-0.5 delta, we have an “At the money” call/put option.
- With a delta closer to 0 we have an “Out of the money” call/put option
- With a delta closer to 1/-1 we have an “In the money” call/put option.
What Delta is telling us?
Delta is multiplied by the change in the underlying asset to determine price change, so the bigger the delta the bigger the price change. With a positive delta, an option price will increase when the value of the underlying asset increases. With a negative delta, a position will increase when the value of the underlying decreases. Therefore, at a positive delta, option traders are hoping for an increase in stock prices and with a negative delta the hope is for a decrease in underlying prices. The further away a delta is from 0, the higher the levels of fluctuation with the underlying price, which means the position taken will be riskier as fluctuations can go either way.
How Delta helps traders predict probability of trade outcomes
Delta also helps options traders to determine the probability of achieving a given result.
- A 0.80 Delta for example would suggest that there is an 80% probability of a call option finishing “In the money”.
- A 0.5 delta would suggest an “At the money” position as the options strike price is same as the underlying price. At this point there is a 50/50 chance of the option finishing either “In or out of the money”.
Time is another factor that affects delta and the probability of finishing “In or Out of the money”. The closer an option is to maturity, assuming the underlying price remains constant, the more the delta will decrease as the probability of achieving a desired outcome dwindles. This is because as expiration nears, there is less time for the underlying price to move above or below the strike price of the option.
Being able to estimate the probability of finishing “At – In – or Out of the money” is extremely important to traders. Delta can quickly tell traders the quantity and type of positions needed to hedge or protect an underlying asset. So instead of having to analyze positions separately, Delta would provide a quick and effective snapshot of all the positions and overall portfolios.
Delta Neutral Strategy benefits
Option traders also utilize Delta Neutral strategies by taking positions where the positive delta and the negative delta amounts to 0 (zero). With this strategy, they are hedging and simultaneously keeping open the possibility of profiting whether the market goes up or down. This strategy is particularly helpful in a situation where traders are uncertain about the markets. To guard against this uncertainty and market volatility, they would take out delta neutral positions thereby neutralizing the directional component until the market stabilises. With this strategy it’s possible to benefit from very volatile stocks that could have huge swings in either direction.
Delta if utilized correctly, can undoubtedly be a vital tool for option traders. This “Greek” can provide great value and insight to option traders and should not be overlooked.
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