Delta: What One Simple Number Can Tell You About Options

An option's delta can help traders decipher what a move in the underlying stock means for their potential profits

Oct 20, 2016 at 2:38 PM
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    Making sense of options pricing is no simple task, especially given the frequent fluctuation of the factors that determine an option's premium. "Greeks" are a set of metrics that determine why, how, and when an option's value will change. Perhaps the most well-known option Greek is delta.

    An option's delta tells traders how much an option's price will change with every $1 increase or decrease in the price of the underlying stock. The delta of a call option will always be a positive number between 0 and 1, since call options gain value when the underlying equity rises in value, while put option deltas will always be a negative number between 0 and negative 1, since a put option loses value as the cost of the underlying equity increases.

    So, let's say a trader bought an XYZ December 55 call, which has a delta of 0.6, or 60%. This means for every $1 XYZ gains, the trader's XYZ December 55 call option increases in value by 60 cents.

    The delta of an in-the-money option will typically be higher than the delta of an out-of-the-money option, since an in-the-money option will move in closer correlation with the underlying equity. An option's delta is thought to correspond with the chances the contract will finish in the money. For example, a call option with a delta of 0.5, or 50%, is thought to have a 1-in-2 chance of finishing in the money. A put option with a delta of negative 0.85, or 85%, has an 85% chance of finishing in the money.

    Finally, delta is also known as the "hedge ratio," since more sophisticated investors often use this metric to determine how to hedge their long and short investments. For example, if you sell to open one call option with a delta of 0.5, or 50%, you might choose to hedge half of your short stock exposure by purchasing 50 shares of the underlying equity.

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