- October 28, 2022
- Posted by: CoachShane
- Category: Trading Article
You’re looking at a few different options to trade and you notice a few choices that have low premiums and are cheap to get involved in. For you, with your smaller account, this may look attractive as you can get several options contracts.
The question for you as an options trader should be “is this a quality position to take”? Cheap is cheap for a reason and in this post, we discuss how to use the “delta” of an option to help choose which options are quality positions and will have the best chance of success.
What you will learn in this article is:
Delta measures the risk of an option by taking into account the underlying assets price, time decay, and implied volatility.
It can also be used to estimate the probability that an option will expire in the money.
Delta is most useful when trading options that are 1-2 strike prices in the money.
When multiple strike prices are within the desired delta range, look to open interest to decide which option to trade.
Delta can be used to offset the effects of time decay.
What Is Delta?
Delta is a measurement of how much an option’s price will move based on a $1 move in the underlying asset. For example, if a stock is trading at $50 and the option has a delta of .50, this means that for every $1 move in the stock, the option will move $0.50.
Imagine you bought an OTM call option on stock XYZ with the strike price of $37.00 and the delta was 0.4034 as seen on this options chain. After a strong move up in the price of XYZ stock, you notice that the delta is now at 0.50. Now, every $1.00 move up in price will be an additional 0.50 price increase with the option.
Call options will have a delta between 0 and 1 while put options will have a delta between 0 and -1. The delta of a call option increases in value as a stock moves up and decreases as the stock moves down. The delta of a put option decreases in value as a stock moves up and increases as the stock moves down.
Because options become more reactive to changes in stock prices as they approach expiration, the delta will increase or decrease at a fast rate. Good news if you are in profit, good news if you are OTM and getting closer to ITM, and bad news if you are OTM and going in the wrong direction.
At the money options will have a delta close to +/- .50. In the money options will have a higher delta meaning they will react faster to the movement in the stock. Look at the delta prices highlighted in the green section (ITM) in the above graphic for examples.
Using a put option example, notice the 37.00 strike price has a -.6004 delta.
Every $1.00 move in the underlying stock will move .60 depending on the direction of the underlying instrument.
Delta can also be referred to as the “hedge ratio” as it tells you how many options contracts you need to buy or sell to hedge, or protect, your position in the underlying asset. While delta can be a useful tool for hedging, it is important to remember that it is not a perfect measure of risk. This is because it does not take into account other factors such as time decay and implied volatility. As a result, delta should be used as one part of a broader hedging strategy.
One other feature of the delta is it can give you a rough indication of the probability that an option closes in the money. If you are looking at a put option with a delta of .60, then that option has a 60% chance of being in the money at expiration.
How Can Delta Be Used When Trading Options?
The worst thing a trader can do is select their options based solely on price. If you want to be aggressive by trading out-of-the-money options with cheap premiums, you are setting yourself up for the probability of a short-lived trading career.
We want the odds in our favor when putting on an options trade. Although buying the basic call and put method of trading is not our preferred approach, I will use that example as we talk about the delta.
As mentioned, at the money options have a delta around +/-0.50. To give ourselves breathing room, we prefer the delta to be in the .60-.65 range for call options (-.6 and -.65 for puts) which means we need to be a few strike prices in the money.
In this example, the underlying stock is trading above $35.00, and as an option buyer, assume we want to take a long position – buying a call option – because we are bullish on this stock.
The numbers highlighted with a green background are all in the money which means the strike price is lower than the underlying. Keep in mind the call option gives the buyer the right to buy the underlying at the strike price. In this case, the $31.00 option contract holder could buy this stock at the strike and then sell it at the market price of $35.00 for a $4/share profit.
Remember, we want to buy the option with a delta between .60-.65. We would look to buy the $34.00 strike price at a premium equal to the mid-point of the bid/ask, or around 3.60-3.65 or $360.00 per contract. Each $1.00 move in the underlying would be an extra increase of .62 for us or $62.00 for the contract.
Multiple Strike Prices
There will be times when multiple strike prices will be hovering within the .60-.65 delta range we look for. When that occurs, we defer to the open interest and volume measures to decide which one to use.
This is not the best example however if faced with these two choices, we’d look to the left to the open interest column. Note that the $40.00 strike has 583 contracts open as opposed to 46 at $37.50. We’d take the $40 strike which also falls into line with us looking at options 1-2 strikes in the money. There is no volume comparison in this example.
When we use a delta between 60-65, we’ve found it gives us a benefit that we can’t ignore. It puts us in a great position at a reasonable cost and a great return on the position in our favor. It also offsets some of the effects of time decay during the life of the contract.
What is Delta?
Delta is a measure of the rate of change in an option’s price, given a $1 move in the underlying asset. Delta can be positive or negative and is represented as a number between 0 and 1 (or 0 and -1 for put options).
How can Delta be used when trading options?
Delta can be used to determine the probability that an option will expire in the money. It can also be used to select options that are more likely to move in your favor and to offset the effects of time decay.
Why is Delta important?
Delta is important because it provides traders with a way to measure the risk of an options trade. Delta can also be used to manage an options position and to adjust for changes in the underlying asset price.
What are some things to keep in mind when using Delta?
Delta is a measure of probability, not a certainty. Delta can also change over time, so it’s important to monitor it closely.
Delta is just one tool that can be used when making trading decisions – it’s not a guaranteed success method but does give you important insights into the contract you are about to trade.
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