One of the first things a new options trader should learn is how to read the “Greeks.” While the price of an option is a function of a risk-free interest rate, dividend, strike price, stock price, volatility, and time until expiration, the option Greeks tell us how much each one of these factors plays a role in the option’s price.
Some of the common Greeks are delta, gamma, theta, and vega.
So let’s dive into the first option Greek you should know, delta, and see how it impacts your trading.
What is Delta?
Delta measures the sensitivity of an option’s price to movement in the underlying stock. Put another way, delta is the amount an options price is expected to move based on a $1 change in the underlying security.
Call options have a positive delta that ranges from 0 to 1.0. This means that with each $1 increase in the stock price, the option’s price will increase by the delta amount, with all other factors held constant.
Put options have a delta that will fall between 0 and -1.0. This negative value indicates that a put option contract will increase in value when the underlying decreases.
For example, let’s say an Apple (AAPL) 200-strike call has a 0.50 delta and is trading at $10. If AAPL is to rise to $202, the price of the option contract is going to be $11. Alternatively, if the same contract is traded, but the price drops to $198, the new option contract is going to be valued at $9.
Note: It’s important to remember that after the stock moves, delta no longer remains the same value, and will continue to increase toward 1.0 or -1.0 the further in the money the call or put option becomes, respectively.
Using Delta to Choose Your Option
Next, let’s take a look at how choosing an option based on its delta can really boost your profits.
|Assume that SPY is trading at $200
You Expect SPY to rise to $220
||$20 increase in stock price
Now, if you expect the price of SPY to rise to $220, you could certainly make an argument to buy any one of these options.
But, it might not be the best trade for you to actually take. Let me explain.
Remember… if the at-the-money SPY 200-strike call option has a delta of 0.50, it will move $0.50 based on every $1 move in the SPY. This means that if the SPY was to move from $200 up to $220, or by $20, through expiration, the value of the option will increase $10.
However, the in-the-money 175-strike call has a delta of 1.0, meaning it will move dollar for dollar with the SPY. In other words, if the SPY was to move from $200 up to $220, the option’s value will increase $20.
While out-of-the-money or at-the-money options require less capital upfront than an in-the-money option, the higher-probability trade for options buyers is with in-the-money contracts. It’s best to decide which level of risk you’re willing to stomach when choosing your option strike.
Time and Delta
The delta of your option will continuously change based on a number of factors. One such factor is time until expiration. As each day passes, an option’s delta will continue to increase or decrease, depending on whether it’s in the money or out of the money.
If a call option is in the money, every day that draws closer to its expiration date will increase its delta to the maximum of 1.0. An at-the-money call option will typically have a delta of 0.5. Meanwhile, in-the-money put options will have a delta nearing -1.0, and delta on at-the-money put options tends to arrive near -0.5.
If an option is out of the money, its delta will begin to decrease toward its minimum value of 0 every day that gets closer to expiration.
This means that if you are trading an option that is extremely close to expiration and has a delta of 0.10, you would need to have a significant increase in stock price in order for the option to see any significant changes in value.
Delta and Implied Volatility
This is a more complex topic but one that should be understood at the basic level.
Fundamentally, if a stock experiences a period of higher implied volatility, it is assumed that each strike is going to be easier to reach by the increase in stock movement each day. Since options are priced based on the likelihood that they will become in the money, the higher this probability, the higher the delta will be for out-of-the-money option contracts.
Alternatively, stocks with a low implied volatility will have higher in-the-money deltas and lower out-of-the-money deltas. By understanding how implied volatility impacts an option contract, you are able to make a more informed choice when trading options that are best for your strategy.
Delta and the Probability of Being Profitable
Delta is also commonly used for determining the likelihood of an option being in the money at expiration.
For example, if an out-of-the-money call option has a delta of 0.20, it’s said to have a roughly 20% chance of expiring in the money.
By looking at delta this way, it gives the trader a good understanding of the likelihood of the option having value at expiration, if they choose to hold it that long.
Additionally, this shows the trader that the underlying stock needs to make a massive move in order for that option to be in the money at expiration. This relationship between delta and the probability of being in the money is why many traders enjoy the benefits of selling options.
By knowing that a trade has a 20% chance of winning on the long side, an option seller is effectively taking the position of the “house’’ at the casino. By having these odds working in your favor, this could allow a trader to generate tremendous income potential just by selling options that have an extremely low probability of being in the money at expiration.
Delta and Your Portfolio
Another use of delta is to measure the amount of directional risk your portfolio currently has.
If you are trading multiple stocks all with positive delta, you will have an overall portfolio of positive delta. But if you are trading a mixed portfolio of long calls and long puts, you may have a delta that is negative, even though you are bullish on the market direction.
In this case, you are going against the viewpoint you may have, and should consider trading options that will balance the delta or push it in your favor. For example, if you are bullish, it’s best to have a portfolio that is positive delta, whereas if you are bearish, you would want to have a portfolio that is negative delta.
And in order to maintain a “risk neutral” trading account, a trader would ideally be looking for a combination of puts and calls that result in the portfolio to be as close to zero delta, or “delta neutral,” as possible.
When you’re getting into options trading, there’s a lot to learn. Some of the most important factors to understand are the Greeks. Basically, you need to understand how your options will change when the underlying stock moves, as measured by delta, as well as how this is affected by time to expiration and volatility.
At the most basic level, you should understand that:
- Call options have a positive delta, and will increase in value if the underlying stock goes up.
- Put options have a negative delta, and will increase in value if the underlying stock goes down.
Additionally, knowing an option’s delta will allow you to gauge the probability a potential trade will be profitable — and whether or not that’s a risk you’re willing to stomach.