Credit: Shutterstock photoSophisticated investors have been utilizing options for decades, hedging their portfolios and generating substantial gains in both bull and bear markets. However, these success stories didn't happen overnight; prosperous option players first armed themselves with an artillery of knowledge. In order to ensure success in your options-trading venture, you must begin by familiarizing yourself with the ins and outs of these unique financial instruments.
In today's edition of Advanced Options , we're going to explore the exciting world of delta , which is the percentage of the price movement in the underlying stock that will be translated into the price movement in a particular option.
Simply put, delta is a measure of how much an option price changes when the underlying stock price changes. The delta of an option varies over the life of the option, depending on the underlying stock price and the amount of time left until expiration.
Delta is arguably the most important options Greek, telling traders how much an option will fluctuate with a $1 rise or drop in the underlying stock. In other words, an option's delta indicates the amount of profit the holder will reap for every dollar increase or decrease in the stock price. The higher an option's delta value, the more it will rise with every $1 increase in the stock.
Options delta values are expressed as a decimal between 0 and +1 or 0 and -1. In other words, delta values are either positive or negative. A call will have a positive delta, as it will gain in value as the underlying stock rises. On the other hand, a put will have a negative delta, as it loses value as the underlying security journeys higher. In layman's terms, options with positive delta (calls) gain value as the underlying stock inches higher, while options with negative delta (puts) gain value as the stock gravitates lower.
It's a general rule of thumb that both calls and puts that are deep out of the money nearing options expiration will have delta values of 0. Meanwhile, calls and puts that are at the money typically have delta values of 0.5 or -0.5, respectively. In this case, a call delta of 0.5 indicates that for every dollar increase in the stock price, the call premium increases 50 cents. Conversely, a put delta of -0.5 means that for every dollar increase in the stock price, the put premium would be expected to drop by 50 cents.
As an in-the-money call option approaches expiration, it will inch closer to a delta of 1. When a deep-in-the-money call has a delta of 1, it will move point for point with the stock. On that note, an in-the-money put will inch closer to -1 as options expiration draws near. So, when the underlying share price decreases, an in-the-money put with a delta of -1 will increase in parity with the stock's trek lower.
Now, let's put it all together... Hypothetically speaking, let's say you've had your eye on Stock ABC, and think the shares are going to move higher in the next couple of months. The security is currently trading near the $95 level, but you predict it will topple the $100 level by June options expiration. With this in mind, you decide to move forward with an ABC June 100 call, which has a delta of 0.8. In other words, for every $1 gain in ABC, your call option gains approximately 80 cents in value.
Best-case scenario: Let's pretend that Company ABC just stepped into the earnings confessional and blew the Street's estimates out of the water. As a result, the shares of ABC picked up steam, skyrocketing to the $115 level. As June options expiration approaches, your in-the-money call boasts a delta of 1, meaning it gains $1 in value for every $1 the stock advances.
Worst-case scenario: Let's pretend that Company ABC stepped into that same earnings confessional, but fell short of analysts' forecasts. As a result, the shares of ABC tumble lower, plunging as far as the $80 level. As June options expiration approaches, your out-of-the-money call eventually earns a delta of 0, as there's little chance of it ending in the money.
Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
