Monday, December 07, 2015

What is Delta?

What is Delta?

When you purchase stock, you are exposing yourself to one dollar of reward or risk. That is, if the stock moves up by one dollar, you make a dollar. If the stock moves down one dollar, you lose a dollar.

Most professional traders when dealing with stock are going to be dealing with round lots or 100 shares since that is the multiplier of an standard equity option. Since the stock moves one for one with price increases or decreases, the stock is said to have a delta of 100. This delta never changes for each unit of stock.

An option on the other hand does not behave this way. The delta of the option is variable and is determined by how close or far away the price of the underlying is in relation to the options strike price.

Let's say that stock XYZ is trading at $82 / share. A trader is long the 90 call option that is expiring in 30 days. Since the current stock price is below the option strike price, we know for sure that option delta will less than 50.

The relation between price and option delta as follows:
  • OTM (out of the money) options have deltas less than 50
  • ATM (at the money) options have a delta that is equal to 50
  • ITM (in the money) options have a delta that is greater than 50
Long position calls have positive delta, while long position puts have negative deltas. Short positions of either will have opposite deltas.

Prices of different options do not change in a uniform way with the price of the underlying equity. The 90 call may only gain 0.35 (35%) for the next dollar move higher in stock. Furthermore, as price approaches the strike price, the amount of delta gaining also changes.

Delta acts like an equivalent to stock shares. In the above example, a 35 delta option is like have 35% of 100 shares, or 35 shares.

Once price has passed the strike price significantly, in this case let's say it reached $100, the option is now ITM and may have a delta of around 80 to 85. It is now beginning to act like a full share of stock.

As the option gets closer to expiration and remains ITM, the delta increases until it becomes essential 100, or equivalent to stock. This is because the time value is disappearing and all that is left is the intrinsic value of the option.

Deltas can also be considered probabilities describing the how much of a chance the option will be ITM. An 85 delta option has an 85% chance of closing ITM and only a 15% of closing OTM for its given expiry.

As you can see there are many factors when considering how an option behaves and changes when the underlying moves. Getting a good understanding of option delta is important when buying or selling options, and when understanding how much of a straight stock position is being hedged. 

Essentially, delta equals risk in your trade.

Understanding how combinations of deltas in your long and short positions contributes to or neutralizes risk is a key to becoming profitable in trading.

Trade safely and always "define your risk".

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