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High Concept: A Lesson on Delta, Courtesy of Delta Air Lines, Inc. (DAL)

Examining delta, aka the 'hedge ratio,' on a DAL put option

by 3/21/2014 10:48:04 AM
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Thursday's most active option on Delta Air Lines, Inc. (NYSE:DAL) was the March 33.50 put, where 1,752 contracts were traded. Roughly 86% of these contracts traded at the bid price, implied volatility on the option fell by 4.2 percentage points on the day, and open interest rose overnight by 1,384 contracts -- suggesting that options players sold to open new DAL puts yesterday.

By selling to open these puts, traders are most likely hoping that DAL remains at or above $33.50 through today's closing bell (when March-dated options are due to expire). If so, put sellers will retain the entire premium collected as their maximum potential profit on the play. The volume-weighted average price on the March 33.50 put was $0.17 yesterday, which means speculators stand to collect $17 ($0.17 premium received x 100 shares per contract) on each option that expires worthless at today's close.

So, with DAL settling Thursday at $33.64, what are the chances those front-month options will stay out of the money through today's closing bell? The March 33.50 put carried a delta of negative 0.40 at the end of yesterday's session, which means the options market was pricing in a 40% chance of those puts expiring in the money -- roughly translating to a 60% chance that the crop of last-minute put sellers will walk away with the maximum possible gain.

While it's generally said to correspond with an option's probability of expiring in the money, delta simply reflects how much value an option will gain (or lose) for each one-point move in the underlying stock. Delta values can range between 1.00 and negative 1.00, with calls carrying positive deltas and puts sporting negative numbers.

If a call option's delta is 0.75, that option will gain 0.75 point for each point gained by the underlying stock. Meanwhile, if a put option's delta is negative 0.75, the contract will lose 0.75 point every time the underlying security rises one point. As expiration draws closer, the delta of an in-the-money call will move closer to 1.00, while the delta of an in-the-money put will approach negative 1.00.

As noted, many traders believe an option's delta approximately corresponds with its chances of expiring in the money. This has earned delta a reputation as the "hedge ratio," since some investors use a contract's delta to determine how they hedge their option trades.

For example, if a trader were to sell to open one DAL put with a delta of negative 0.40, he might choose to buy 40 shares to hedge his risk of assignment. Since each option covers 100 shares of the underlying stock, he's effectively hedged 40% of his trade. This type of position is considered "delta neutral," since the purchased shares are sufficient to offset the delta risk on the option.

As for yesterday's put sellers, they might be unpleasantly surprised by DAL's trip below $33.50 earlier today. With expiration just hours away, and the shares currently hovering at $33.57, delta on those March 33.50 puts has spiked to negative 1.00.


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