Last Update: August 2021
In this article, Gino Poore delivers a great lesson on understanding and using the Delta of an option.
What is Delta?
DELTA is a very useful tool to an options trader. Delta, Theta, Vega are the 3 big greeks that affect an options price that you must know thoroughly as an options trader.
I have taught and met many option traders over the years, and it is amazing how an understanding of option measurements such as the Greeks can drastically improve one’s trading. Of these, the “delta” of an option is one of the most commonly used greeks for trading options. The three uses of the delta I will explain here will help all options traders both directional and non-directional.
The delta, derived from a theoretical pricing model like Black-Scholes, is a number between 0 and 100 that has a variety of different uses and interpretations including:
- The change in the price of an option.
- The probability that an option will expire ITM (In The Money).
- A representation of stock ownership.
How to use Delta Case #1: What to expect in the next move of the stock
The first most common uses of the delta is to measure the change in an option’s value given a $1 change in the underlying stock. For example, imagine that a stock trading at $49 has options with the following deltas.
XYZ Stock Price: $49 (28 days to expiration)
Lets focus on the 55 call & put. If the stock moves 1 point from $49 to$50, the 55 call option premium would rise 32 cents per contract and the 55 put would drop by 68 cents. And just the opposite if the price of the stock was to drop by one point.
How is this useful?
Well, if you are a directional trader you can see that if you were to buy a 55 call, you can expect a 32 cent gain in your option if it moves up a point, but you would make twice as much if you would have bought the 45 call. Then again on the downside, if the stock were to drop a point, the 55 calls would lose half as much as the 45 calls. Therefore based on your outlook of the stock and risk tolerance you could better calculate which option gives you the best risk/reward. Remember the “D” for Delta tells the Directional trader how much they will make on the stock moving in a direction up or down. Delta traders are Directional traders.
How to use Delta Case #2: The Probability of the trade
The second use of delta is the % chance, or probability, the option strike price will expire in the money. Notice the deltas in the table above. The deeper ITM a strike is, the bigger the delta. With 28 days left, the 45 call has a 64% chance of expiring ITM while the 55 call has a 32% of expiring ITM.
Notice the 50 calls have a + 48 delta, while the 50 puts have a -52 delta. Thus, the 48 delta of the call can be interpreted as a 48% probability the option will finish in-the-money. Considering the option is only 1 point away with the stock at $49, it makes sense that the option would have a slightly less chance of finishing in-the-money compared to the 50 put which is already 1 point in-the-money. In a perfect scenario, if the stock was right at the strike price, the delta of the call and put would be 50. This is because on the next trade there is a 50% chance of it going ITM on the call or the put. This is why the sum of the call and put deltas add up to approximately 100. A good rule of thumb is:
- ITM options – Deltas are greater than 50.
- ATM options – Deltas are about 50
- OTM options – Deltas are less than 50
How is this useful?
Well let’s say you want to sell a put for a credit. If you sell the 45 put at this point, there is a 36% chance of the stock dropping to 45 in the next 28 days. Therefore you have a 64% chance of it expiring worthless. And if you were to sell a 55 call against your stock position, you would have a 32% chance of your stock being taken away, and a 64% chance of the call expiring worthless.
So what’s the probability of you profiting on your current position?
Just take your B.E. (break-even point) to the chain. What would its delta be? For example, if you bought the 50 call for $2.50. Your B.E = 52.50 by expiration. Therefore, you can see that your delta or probability of profiting is about 40%. Right in the middle of the 50 & 55 strike deltas.
How to use Delta Case #3: How to protect your position
Third and Lastly, delta can represent how much stock you control. So if you own the 50 calls with the 48 delta, you can expect to make $48.00 on the next 1 pt. move up in the stock. That would be the same as if you owned 48 shares of the stock by itself. This is the main advantage of options. You are controlling in this case 48 shares for a fraction of the cost of buying the actual 48 shares of stock. And to make it better, the deeper ITM your strike goes, the higher your delta goes. This means you are controlling more shares when you are right and less shares when the stock goes against you.
How is this useful?
Lets assume you own 100 shares of XYZ at $49 and you want to protect it from a big move coming up. You can buy 2 of the 50 puts and you would have a total delta of –104, which is the same as shorting 104 shares. This means you just neutralized your position and in trading terms you are delta neutral. This would not only protect your position, but also be profitable in a big move. Or maybe you have a call spread with a delta of 25. You might go delta neutral by shorting 25 shares of the underlying stock or buying a put with a delta of –25. Using good software or brokerage platform, you can evaluate the possibilities with ease on the P&L graph.
You can see how valuable the knowledge of options can be to your trading. Just the delta alone tells you:
- What to expect in the next move of the stock.
- The probability of the trade.
- How to protect your position.
It is a very important Greek. My advice as a trader and mentor is to get a good grasp on the basics, “The Greeks” and work your way up from there. We teach you the power of option trading. Options give you an advantage. Options give you leverage. Options give you options.
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6 Replies to “Options for Beginners: Meet a Popular Greek Named “Delta””
The title of this makes me want to respond with a “Help ya help ya help ya.” like the Saturday night live skit from the early nineties
True! LOL !!
Great explanation, and very thorough. Thanks so much, Gino!
Awesome explanation on Delta, Gino!! Thank you very much!!
Thank you Gino. You rock!
I really didn’t know and appreciate the Greek until reading this. Thank Gino for such another great lesson again.
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