Using Option Greeks: Delta

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Option greeks are a way to measure an option’s sensitivity to the underlying stock, interest rates, market volatility and the passage of time. In this article we will be looking at each of the common greeks used by investors. This article will begin our discussion of the first of these greeks, delta.

[VIDEO] Using Options Greeks Delta: Part 1

Delta is a measure of the rate of change in an option’s price for a $1 move in the underlying stock or index. If a particular option contract has a delta of .5 and the underlying stock moves by $1.00 then the option’s price should increase by $.50 per share or $50 per contract.

It gets a little more complicated because delta will grow as a stock option goes further in the money. For example, if the $25 strike price call has a delta of .50 on a stock that is currently worth $25 per share we could expect a $.50 move in the option for a $1.00 move in the stock. But if the option subsequently becomes “in the money” delta will increase and could rise to .70, .90 or even 1.00 for a very deep in the money call.

Conversely, delta will fall as an option becomes “out of the money.” Using the same numbers above, if the stock falls to $20, the $25 strike call may have a delta of .2 or less.

Delta works the same way for puts with an important difference. A put’s delta will always be negative. What this means is that if the stock rises by one dollar the negative put delta shows how much value we should expect the put to fall.

Conversely, the negative delta also predicts how much value we expect to gain in the put’s premium if the stock falls a dollar in value. In the money puts have a larger negative delta and out of the money puts have a lower negative delta. Besides this minor notational difference, this greek works the same way for both calls and puts.

Despite this fairly straight forward explanation, delta can be a little tricky from a practical perspective. First, using it to forecast price changes only works if everything else in the market stays constant. That means that delta is at best only an estimate of what price changes should be expected if the underlying stock or index only moves $1 in a very constant market over a very short period.

Another way to look at delta is that it is an efficient estimate by the “market” of the probability that an option will expire “in the money” by expiration. This makes sense for an at the money option to have a delta of .50 because reasonably it has a 50% chance of closing in the money by expiration. Similarly, the more out of the money an option is, the lower the probability is has of expiring in the money.

Because there is no way to determine the real likelihood of an option’s chances of expiring in our out of the money, delta is a great way to create an estimate. This can be helpful for option buyers or sellers who want to model their chances of success in a given trade relative to the amount of risk they are taking. This is a subject we have expanded on in our articles on position sizing and money management.

Delta grows larger with in the money strike prices. Eventually, Delta can become almost equal to 1.00. That means that for the first $1 move in the stock or index the option will grow by $1.00 per share or $100 per contract. The further out of the money a strike price is the smaller delta becomes. An option that is several strike prices out of the money may have a delta as low as .10. That means that for the first $1 move in the stock, these out of the money options will only grow $.10 or $10 per contract.

[VIDEO] Using Options Greeks Delta: Part 2

At first glance it may appear that an in the money strike price is the better deal but delta and option premiums grow together. The higher the delta, the higher the option premium will be compared with options on the same stock and with the same expiration date with a lower delta. A deep in the money option may cost several times the price of an out of the money option. In today’s video I will contrast three different strike prices to show the difference between the deltas, option premiums and potential rates of return for the first $1 move in an ETF. What you will find through the example is that the lower deltas offer a higher potential return percentage but they also promise much more potential volatility.

The reason delta is an important concept to understand is very well demonstrated by the movement of the calls we have been evaluating in this article. Out of the money options have a low delta but also have a low cost. When you are anticipating a very big move in the near term, an out of the money option with a low delta can actually return the best on a percentage basis because it is initially inexpensive and its delta will increase dramatically as it moves further in the money.

[VIDEO] Using Options Greeks Delta: Part 3

In the video above the I will walk through the expiration prices of each of the three deltas we sampled in this series. The stock used was GLD an ETF that tracks gold prices. GLD experienced a dramatic increase in prices pushing all three strikes into the money. The out of the money option had a much higher percentage return than either of the other two options. In this case, the out of the money option made sense because the market was so volatile and gold is a traditional hedge against uncertainty. During “normal” or less volatile market conditions, the at the money or in the money option would have been the better choice because prices moves slower and the out of the money option has a higher probability of expiring worthless. Delta can help us make those decisions and to understand what the risk of a particular trade is today.

GLD iShares Gold Trust
GLD iShares Gold Trust