by Ken Trester 07/31/08
Option delta refers to the ratio of change between the underlying asset's price in relation to the change in the option's price, which can help to explain why an option makes corresponding moves with the underlying stock or why it might refuse to go along for the ride in lockstep.
One of the benefits of trading options is that you can capture huge swings (in the double- or even triple-digits) on a simple single-digit spike in the underlying security. An option's delta aims to approximate how much an option will change in price for every $1 move in the underlying stock.
The deeper in-the-money the option is, the higher the delta and, thus, it's more likely that the option moves in tandem with the stock. (That is, if the stock jumps $1, the option could also go up $1.) This is the ideal situation for profitability, when the option movement directly mirrors the stock movement.
This ratio of change between the price of the underlying asset and the option is reflected as a percentage, where a delta of 1 for the underlying instrument (i.e., stock, index or Exchange-Traded Fund) equals 100%. In turn, an option's delta can never exceed 100% of the stock's movement and is instead conveyed as a positive number (with bullish plays) or a negative number (in bearish trades).
In other words, it measures how much an option's price will change in tandem with every $1 move in the underlying security. If the stock jumps $1 and an in-the-money call option also goes up $1, that option has a positive 100 delta. But if the option goes up 50 cents against the stock's $1 increase, then the option's delta is a positive 50 (or, it has matched 50% of the underlying's move).
A delta of 50 is typical for an at-the-money option; that is, if you're holding a call at the $100 strike and the stock is trading at $100.
Simply put, the option has a 50% chance of going in your favor. Thus, the deeper-in-the-money calls have higher deltas because their chances of finishing profitably are, of course, higher, and lower deltas correspond to an option's chance of being profitable by expiration.
But what if the $100 stock goes down to $99? Then an option with a delta of 50 goes down 50 cents, or half of that $1 drop. However, if it's a put option that drops 50 cents with a $1 spike in the stock, it would have a negative 50 delta, as it drops 50 cents for every dollar that the stock price increases.
Delta is one of many tools that can help option investors to gain a statistical advantage over other traders, because it helps us to determine whether we have an under- or overvalued situation or a good risk/reward picture.
Otherwise, we pass on the trade -- why invest in san option trade that "might" do well when we can instead identify trades that have the odds stacked in their favor?
If you enjoyed this article, check out Ken Trester's "Stay Invested During Volatile Times" and "Cheap Options Aren't Always a Smart Buy."
5 Ways to Profit From Volatility
The crazy volatility spike has some people shying away from trading, and they're missing out. Find out how to use volatility to your advantage.
Volatility: The Option Buyer's Secret Weapon
Many experts claim that buying options is a sucker's game, but they don't understand the rules.
Diversify Your Options Universe
Diversity makes the world go 'round, and the same is true of your portfolio.
Give Yourself Time to Be Right
Risk is everywhere on Wall Street, conquer it with stock options.
Stay Invested During Volatile Times
Hanging on during a wild roller-coaster ride of market volatility takes research and thought. But the payoff can be exciting.
