Back-to-basics 7: Delta

What are options - and why add them to your portfolio? In this back-to-basics series, TradeKing’s Brian Overby explains options from the beginning, from opportunities to risks. This post discusses “delta”, the most popular options “Greek”, and how you can put delta to use.

Hello, traders! So far in this beginner’s blog series we’ve defined options, both calls and puts, explained what sports and movie contracts have in common with investment options, and showed how an option contract’s terms are spelled out in its name. We’ve also examined the basic parts of an options chain, including glossing key concepts like delta, open interest and implied volatility.

In my last post I unpacked “open interest” as an important measure of an option contract’s liquidity. Today we’ll talk about another concept from the option chain, delta.

Most traders have heard of delta -- it's probably the most widely quoted of all the Greeks. (Collectively, the “Greeks” refer to a set of calculations with mostly Greek-sounding names like delta, theta, vega, gamma and rho. The Greeks help you measure the impact of certain variables – like interest rates, time passing, and so on – that will likely affect the price of your options contract. We’ll eventually cover each of these.)

So chances are you’ve heard the term “delta” before. But do you realize how useful it can be in your options trading?   

A common mistake amongst option traders is that they don’t have realistic expectations for the price movement of the option contracts that they trade. Options are a derivative, which means they are derived from an underlying stock’s price. When something is derived from something else it usually does not move tick for tick with the underlying.

All options are definitely not created equal, options with different strikes move differently when the underlying price moves up and down, and as the option approaches expiration. Is there any mathematical way to predict how much your option will move as the underlying moves?

Yes. The answer is delta. Delta holds the key to understanding how and why an option moves the way it does.

Delta is the amount a theoretical options price is expected to move based on a $1 change in the underlying stock. Consider stock XYZ at 50, and imagine we’re looking at a 2-month call with a strike price of 50. Since the strike price equals the current stock price, we’re talking about an at-the-money (ATM) option, whose current price is $3.

Now imagine the stock moves from 50 to 51 right now, with no other variables budging. How much can you expect the option price to move?

It might be tempting to say the option will also move $1, but that doesn’t make sense if you really think about it. After all, the $3 option costs much less than the $50 stock. Why should you be able to reap the same price move benefit with the option as with the stock?

If you know the option’s delta, you have your answer. This theoretical call’s delta is 0.50. By definition, then, if XYZ moves from 50 to 1, that $1 price change should see a corresponding move of $0.50 in the option price, from $3 to $3.50.

Let’s look at our trusty IBM November options chain again:


 
See a larger version of this image.

Two things should leap out at you right away about delta:

Delta is a number between 0 and 1. It’s positive for calls and negative for puts. Like our theoretical example above, that XYZ 50 call had a positive delta of 0.50; when XYZ moved from 50 to 51, the option should move from $3 to $3.50.

Puts work the opposite way. Take the 120 put, with a delta of -0.393. That suggests the following: if IBM moves up $1, from $123 to $124 in this example, in theory the 120 put should go down in price by around $0.39. If the current price of the 120 put is 1.90 (ask), a $1 drop in IBM’s price with no other variables changing should move the options price to about $1.51.

Delta differs from strike to strike, even on options with the same expiration. In other words, there is no “universal delta” applying to all IBM options. Just scanning the delta column on both the puts and calls side of this chain should make clear that delta is calculated differently for each contract. We’ll discuss delta’s dynamic relationship with other variables in a future post.

I’ll leave you with a pop-quiz to ponder for next time. What would happen if stock XYZ moved another $1, this time from 51 to 52? Would the option also move another $0.50? Stay tuned for the answer next time!

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

[image: Circle and Triangle by billjacobus1 on Flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. 

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While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.

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