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Understanding Delta is the Key to Option Profitability - Know Your Options

By: Zacks.com
Posted: 3/14/2013 5:06:00 AM
Referenced Stocks:

Understanding Delta is the Key to Option Profitability

One of the most important things to understand in options trading is delta.

It's actually quite easy to understand. But this subject is not talked about enough. And why I'm writing about it today.

Delta, essentially, is a way to measure how much an option will increase or decrease in value based on the change in the underlying stock.

The definition of delta as it applies to options is: the percentage an option will increase or decrease in value in relation to the price movement of the underlying stock.

For example: a delta of .60 or 60% means the option will move or change in value equal to 60% of the underlying stock's price change, which means a $1.00 rise in the stock should see a 60 cent rise in the option premium. If the stock fell by -$1.00, the option should decrease by -60 cents.

There's second part though to understand this fully.

The delta will change (either increase or decrease), in general, based on how 'in-the- money' or 'out-of-the-money' your option becomes.

For instance: if a stock is trading at $85 and let's say you had a $95 out-of-the-money call option with 4 months of time on it; that option might have a delta of .41 or 41%. Let's also say that option was priced at 6.00 or $600.

Now let's say the stock increased by $10. This means that out-of-the-money call option with a delta of 41% would've increased by $4.10 or $410.

Now, that option is at-the-money.

Remember, the option's delta will increase or decrease based on how 'in-the-money' or 'out-of-the-money' the option becomes.

So now your option is at-the-money. Now instead of your delta being 41%. It might now be 60%. If Amazon were to then increase another $10, that option would now increase by another 60% (60% of the $10 move) or $6, i.e., $600.

And as the price goes up, and the more your option gets 'in-the-money', the bigger your delta will become until it gets to be 100%.

Likewise, the further 'out-of-the-money' the option gets, the smaller the delta becomes.

So when you're deciding what option to buy or sell, look at the delta so you can get an idea as to how much your option will increase or decrease based on the underlying price of the stock.

So knowing your option's delta is one of the keys to picking the right option to get into.
You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here .

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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