Delta: Breaking Down the First of the GreeksAM
Hey guys, I've seen a few threads on options trading and how important the Greeks are to your overall options trade. I found a great read courtesy of OptionsHouse that breaks down Delta for those that are interested.
Delta is a numerical value that describes an option in several interesting and useful ways, such as how much the option’s price should move for a $1 move in the underlying stock, how much the option is almost exactly like its stock, and what the probability is of the option being in-the-money by expiration.
A short definition of delta would be the sensitivity of an option’s price to changes in the underlying price. A shorter definition would be the speed of the option. If an option has a delta of 0.500, you can think of this as 50% and it means that if the underlying stock moves $1 (higher or lower), the option price will move only 50 cents (again, higher or lower).
The option pricing model assigns a probability to every option that quantifies the likelihood of that option finishing in-the-money (ITM). This number is the delta, and it changes dynamically as underlying prices change and time passes. The number produced by the pricing model is between 0.000 and 0.999, and traders speak of 0.103 as a “10-delta” and 0.591 as a “60-delta.”
How to Use Delta to Gage Option Buying vs. Selling
Some traders may use changes in delta to figure out if options are being bought or sold. Since option markets are so liquid and competitive, option prices tend to move in lock-step during the trading day with their stocks. So you would expect all “30-delta” options to move about 30 cents for every $1 move in the underlying stock. A $1 up move would have the calls up 30 cents and the puts down 30 cents, and vice versa for a $1 move lower in the stock.
What if the stock moved $1 higher and the 30-delta calls only moved 15 cents higher? Someone was probably selling those calls (trading them on or near the bid) and the market makers were perfectly willing to let them do so. What if the stock moved $1 lower and the 30-delta puts moved 50 cents higher? It’s likely that someone was buying those puts (at or near the ask price) because they moved far higher in price than their delta would dictate was fair value.
Three Ways to Think About Delta That Make It Such a Great Tool
Here’s a handy reference guide to delta to help you remember its power…
1. Delta is the rate of change of the option relative to its underlying stock—in essence, the speed of the option.
2. Delta is the probability the option will finish in-the-money—i.e., how likely is it the option will end up trading for parity because it is virtually equal to a position in the stock from the strike price?
3. Delta is the “hedge ratio” or equivalence to the underlying stock—i.e., it tells you how much stock you need to buy or sell to exactly hedge an option position.