One way to use Delta is to determine the chance that an option will be in the money at expiration. As a simple example, a 30 delta suggests that the option has a 30% probability of being in the money at expiration.
If you’re trading call options and the underlying asset rises, then the delta of that option would increase, because the probability of finishing in the money also increases.
Often professional option premium sellers utilize delta to estimate the probability that they will be assigned at some point prior to expiration.
And if you are trading put options with a delta of 25% and the underlying asset increases in value, the put option would decline in value and the delta would decrease, because the odds of that put expiring in the money decreases when the underlying asset gains value.
A 50 delta suggests that the option has a 50-50 chance of ending up in the money at expiration, because the odds of the option ending up in the money or out of the money is split in the middle.
If you see a large price move in the underlying asset, but you don’t see the option move in proportion to the underlying asset, the answer is usually delta. One of the biggest mistakes made by beginners is not paying attention to the delta when initiating long positions and then realizing when it’s too late that the gain in the option was disproportionate to the gain in the underlying asset by a large margin.
You should always keep in mind that delta represents the expected price move in the option for a dollar change in the underlying asset and you should always check the delta before purchasing an option, especially one that’s out of the money, which usually results in delta below 50 — that means that in the best case scenario the underlying asset will move only $0.50 for every $1.00 rise in the underlying, at least initially, since delta increases as the price of the underlying asset continues to increase.
There are several important facts about delta that you need to keep in mind:
- Every option has a unique delta that’s constantly changing.
- As an in-the-money call option nears expiration, it will approach a delta of 1.00, and as an in-the-money put option nears expiration, it will approach a delta of -1.00.
- You are long delta whether you are buying delta positive options or selling delta negative options. Call owners may lose money even when delta is increases. The passage of time or decreasing implied volatility can impact the options price by more than the change in the assets price.
- If you are long a 70 delta call and short 70 shares of stock, you are delta neutral and have no market risk until delta shifts or changes.
- Delta is commonly referred to as a hedge ratio because it tells you how many shares of stock you need to sell when buying one call option or conversely, if you are trading to the short side, it would tell you how many shares of stock to buy against a long put position.
- When an out of the money call option approaches expiration, the delta will begin approaching zero, because a powerful move will be necessary for the option to end up in the money with such a low delta; and the probability of that happening is extremely low prior to expiration, because there’s virtually no time left for the asset to move.
- A solid understanding of Gamma is needed, because it defines exactly how much the delta will change as the underlying assets price moves up as well as down.
- With call options, a delta of 0.9 means that for every $1 the underlying stock increases, the call option will increase by $0.90. Put option deltas, on the other hand, will be negative, because as the underlying asset increases in price, the value of the option will decrease.
- A put option with a delta of -0.9 will decrease by $0.90 for every $1 the underlying increases in price.
In conclusion, knowing how to interpret the delta of the option before initiating either a long or a short position can help you determine the probabilities of an option expiring in the money and help you gain a better perspective on the current market sentiment.
Wishing you the best in your trading.
Roger Scott is the Head Trader at Wealthpress.