Option “premiums,” that is, the prices that a trader must pay if he or she wants to buy an option, or the price that they will receive if they sell the option, are determined by a number of variables.
These variables include the price of the underlying stock (or security), the volatility of the stock and the amount of time before an option expires.
Measuring the sensitivity of an option’s price to these variables helps us analyze how an option will react to changes in the underlying stock.
A group of metrics used to measure these different factors that impact the price of an option are given the name “option Greeks,” because of the Greek names used to represent them: delta, theta, gamma, vega and rho.
One of the most valuable Greeks for option traders is “delta,” which we’ll examine here.
Options Delta Definition
The delta metric can tell us several important characteristics about an option. First, delta tells us the relationship between the change of an option’s price and the underlying stock.
Delta indicates how much the option price will change for every $1 move of the stock, assuming all else is equal. A delta of .70, for example, means that there will be a 70 cent move in the option’s price for every $1 move in the stock price.
Values range from 1.0 to -1.0 (sometimes shown as simply 100 to -100). Call option delta values range from 0 to 1.0, while put option delta values range from 0 to –1.0.
- A positive delta is when you are long; you benefit when the stock price goes up, with risk to a downside move in the stock price.
- A negative delta is when you are short; you benefit when the stock price goes down, with risk to an upside move in the stock price.
- A delta of zero is “market neutral”; there is no directional bias toward the upside nor the downside.
- A long call will have a positive delta, while a short call will have a negative delta.
- A long put will have a negative delta, while a short put will have a positive delta.
- A short call will have a negative delta. This is because it will benefit when the stock price decreases.
- A short put will have a positive delta. This is because it will benefit when the stock price increases.
As you can see, when an option has a negative delta, for every $1 downward move in the stock’s price, the option will decrease by the value of the delta.
When an option has a positive delta, for every $1 downward move in the stock’s price, the option will increase by the value of the delta.
Consider Our Article: Trade Covered Call Options – Earn a Monthly Income Writing Covered Calls
Stock Options Delta: Bullish or Bearish
Knowing this, you can see how delta can tell you if you are directionally biased and in which direction, up or down. A positive delta indicates a bullish position.
You’ll want the stock price to go up so that your option will increase in value. Conversely, a negative delta indicates a bearish position. You’ll want the stock price to go down so that your option will increase in value.
As you know, a long call makes money when the stock’s price goes up, and a long put makes money when the stock’s price goes down. Of course, this assumes all other variables that comprise an option’s price do not change.
By looking at all of the delta values of the options in your portfolio and adding them together, you can see if your overall portfolio is biased in the bullish or bearish direction.
Some traders try to keep their portfolio totals close to zero, neutral, as a way to protect against a strong market move in one direction or the other.
Probability Of Profit (POP)
Traders can also use the option delta formula to help determine the probability of an option finishing in-the-money (ITM). A call option that has a delta of 0.40 (sometimes written as simply 40), then there is about a 40% chance that the option will finish in-the-money at expiration.
This number can be subtracted from 100% to tell us the opposite, that is, what is the chance of the option being out-of-the-money (OTM) at expiration. In this case, that would be 60%.
This is especially important for trading credit spread strategies (bull put credit spreads and bear call credit spreads), because typically these strategies are designed to make money up-front by selling out-of-the-money spreads with the hope that the spread will be out-of-the-money at the option’s expiration, thus allowing the trader to keep the full premium he receives at the outset of the trade.
The higher the delta value, the more sensitive the option’s price will be to changes in the stock price. This is true for both positive and negative deltas.
Also note that delta values tend to increase as time gets closer to the expiration date for near or at-the-money options.
Equivalent Shares Of Stock
Delta also gives you an approximation of the number of stock shares an option (or option position) is theoretically equal to.
For example, a delta of 0.50 means the option is similar to owning 50 shares of the stock (0.50 x 100 shares per contract).
A put spread delta of 1.40 means the option trade is the theoretical equivalent to 1.4 shares of the underlying stock or security.
In Conclusion: Options Delta Explained
Delta is a measure of how responsive an option’s price is to changes in the price of the underlying stock. It can tell us the probability of an option expiring in-the-money or out-of-the-money by the expiration date of the option.
Delta will change as factors such as the price of the underlying stock moves, volatility changes and the days until expiration dwindle.
Consider the option delta formula: Delta = probability of ITM.
So for example, an out-of-the-money -.30 short call has a 30% probability of expiring in-the-money at expiration, which also means that it has a 70% chance of finishing out-of-the-money.
Trading Volatility has an Option Delta Calculator you can use for free.
Use stock options delta as your directional risk gauge.