Chris Rowe

How Delta Can Make You Millions

    Tweet This

Free Trading Guides

The key that unlocks the door to positioning yourself with the risk/reward ratio that you once thought only institutional traders are offered can be found in the options pricing model, which has several variables called "the Greeks." And the place to start when it comes to understanding how options pricing works is with the options' "delta."

Just to refresh, delta is the ratio comparing the change in the price of the underlying asset (such as a stock or ETF) to the corresponding change in the price of an option contract. For example, an option contract that has a delta of 0.65 should (theoretically) advance or decline by 65 cents if the stock moved up or down by 1 point.

We have been talking about it, not so much as a tool or a calculation, but more as a concept. We don't have to get into a deep discussion about the actual deltas of the options that I use as examples because the goal is for you to have a clear understanding of the reasons option prices change the way that they do. 

Making Profits Starts With Keeping the Money You Already Have

Today you'll learn how to lock in the profits that you'll have on the table when you find yourself in a winning trade that you're not ready to exit ... and I'll show you how that relates to the option's delta.

It's simple, really. If you own an in-the-money call option (which is a bullish stock-replacement strategy) and the stock advances, then your call option should advance. 

When that happens, you can lock in the profits you have on the table (because the price of the call option increased) by exiting the call option that you own and buying a different call option, on the same stock, but with a higher strike price. 

Here's the Basic Idea ...

At the time I wrote this, Apple (AAPL) was trading at $161, so let me take you through the process of vetting its options as potential trades based on their delta. (Note that this is for example purposes only.)

The AAPL Jan 140 Call (which is 21 points in the money and has a delta of 0.75) is trading at $28. That means that this $28 call option has 21 points of intrinsic value, and 7 points of extrinsic value ($21 plus $7 = $28).

Since it's trading at $28, you know $28 is the absolute most that you can lose -- even if Apple declines by $100. So, basically, the most we can lose is 17.4% of the entire value of Apple's stock (17.4% of $161 is $28).

If Apple advances 18.6% from $161 to $191 within a month, the call option will probably advance from $28 to $53. That means the call option that was 21 points in the money is now 50 points in the money. And when an option moves deeper in the money, as it did in this example, the delta increases. The delta in this case would increase from 0.75 to about 0.95.

Since our Jan 140 Call would be trading at $53 after Apple's advance, you know $53 is then the absolute most that you can lose -- even if Apple declines by $191. 

But why risk the entire $53? I would rather only have only $28 at risk, as we originally did.

The stock may possibly decline, causing your $53 call to trade down to $40, giving back about half of the profit you had at $53. The stock could decline even more, sending the call option to $27 -- giving back ALL of your profit plus a point. Or, even worse, the stock could decline even more, causing you to see a large LOSS on the call option!