A Quick Primer on Delta for Options Traders

How to analyze your profit and loss potential using option deltas

Nov 1, 2015 at 10:00 AM
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    Options are derivatives, in that their prices are derived from the value of an underlying security (whether that be a stock, index, or ETF). But that's the easy part. A number of other elements -- time decay, implied volatility, etc. -- are factored into an option's price. So is there a way to determine how much an option's value will shift based on how much the underlying security moves? Yes -- just look at its delta.

    Delta, a so-called "first-order Greek," is arguably the most widely watched metric of its kind. It provides a quick-and-dirty way to see how option prices will react to changes, whether positive or negative, in the underlying security. Specifically, an option's delta indicates how much value the option will gain or lose on a 1-point rise in the underlying asset.

    Call options have positive deltas between 0 and 1, as their value will increase on a rise in the stock (all other factors being equal). Put options have negative deltas between 0 and -1, as puts will decrease in value when the stock rises.

    Additionally, in-the-money options have higher deltas (as they move in closer sync to the underlying), while out-of-the-money options typically have lower deltas. An option's delta is also impacted by the amount of time remaining until expiration; longer-term options, such as LEAPS, tend to have higher deltas than options with mere days (or hours) until expiration.

    Delta also reflects the options market's expectations of the percentage chance an option has of being in the money when it expires. For example, a delta of 0.33 for a call suggests the market is pricing in a 1-in-3 chance of being in the money at the closing bell on expiration Friday.

    Traders can also use delta to estimate gains or losses in their option positions. A delta of 0.75 for a call suggests the option should rise $0.75 for every $1.00 advance in the stock, and lose the same amount for every $1.00 the stock falls. Conversely, a delta of negative 0.75 for a put option means the option will gain $0.75 each time the stock loses $1.00, and drop $0.75 if the stock were to rally $1.00.

    But delta is not a static measurement. Delta -- like the movement of the underlying security itself -- is fluid, and can change rapidly in response to the fluctuations of other factors. If an option is gaining or losing more (or less) than its delta had suggested, it is likely because other variables are shifting as well. For example, increased implied volatility would raise the price of an option, regardless of what the stock is doing on the charts.

    Nevertheless, this Greek is a good starting point for evaluating how your option will respond to future price action in the underlying security.

     

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