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So You Want to Trade Options: Five Burning Questions About Delta

Reviewing some frequently asked questions about delta

by 11/25/2009 2:45:10 PM
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For example, if you buy an out-of-the-money option and the stock price rises as you expected, your option will go in the money. As a result, the delta will move closer to 1, or 100%, as expiration approaches. These changes to your option's delta are quantified by a separate Greek, known as gamma. Specifically, gamma reflects the unit change in the delta for a one-point change in the underlying stock or index.

How does an option's delta affect its price?

This is technically a trick question, although I can appreciate that it was not intended as one. Delta, in and of itself, has no effect on the price of an option. Factors such as implied volatility, dividends, and time until expiration can all exert an influence on an option's price. However, delta can only tell you how much the option's price will change as the result of a price change in the underlying equity.

I've heard some traders refer to delta as the "hedge ratio." What does this mean?

Since an option's delta is thought to roughly correspond with its chances of finishing in the money, as noted earlier, some traders use delta as a guideline for hedging their positions. Let's say that you write a call option with a delta of 0.50, or a 50% chance of finishing in the money (in theory). Using this as your "hedge ratio," you might choose to hedge only half of your potential loss by purchasing 50 shares of the underlying stock. If your option's delta rises to 0.70, you could build your hedge to 70 shares -- and so on.

What does it mean to trade delta-neutral calls or puts?

deltaDeltra-neutral trading takes the theory of the hedge ratio one step further. By trading delta-neutral options, you're trying to eliminate directional risk, with all of the positive and negative deltas in your portfolio canceling each other out as completely as possible for a sum of zero -- or very close to zero.

This tactic is particularly handy for market makers, who honestly have enough to worry about without picking a bullish or bearish bias like the rest of us. But those of us who are purely garden-variety traders can also use this strategy to hedge against downside moves. You can delta hedge a stock position through the use of an option, or vice versa, or both.

For example, maybe you wrote two out-of-the-money calls, each with a delta of 0.50. By purchasing one in-the-money call with a delta of 1, you've achieved delta neutrality. (However, note that your position is not fully hedged -- only delta hedged.)

Keep in mind, too, that you're probably not a market maker, and a hedged position will usually involve some downside on one end of the equation and it could limit your profit potential. In other words, there's no need to abuse the privilege and hedge just because you can. Like Spiderman, you must use this power with great responsibility.

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