What are options - and why add them to your investing mix? TradeKing’s Brian Overby takes you back-to-basics, explaining options from the bottom up. This post continues a discussion of “delta”, the most popular options “Greek”, and how it helps options traders. 

We’ve covered lots of ground in this blog series for beginning options traders. If you’re just joining us, check out the section below entitled “Catching up? Previous posts in the Options Guy’s back-to-basics series”.

Today’s post will again deal with delta, which we’ve previously defined as the amount an options price is expected to move based on a $1 change in the underlying stock.

But there’s another way you can look at delta: the probability an option will wind up at least $0.01 in the money at expiration. Technically, this isn’t a perfectly accurate definition because the actual math behind delta is not an advanced probability calculation. At the same time, chances are you’ll find this a handy way to think about delta as expiration nears.

We said earlier an at-the-money option usually has delta of 0.50 (also called simply “a 50 delta”). That means there’s a 50/50 chance this option winds up in- or out-of-the-money at expiration.

As expiration nears, there is by definition less time in which the stock can stage a big move. If your option has been drifting further in- or out-of-the-money over time, its probability of switching courses narrows. Because probabilities are changing as expiration nears, delta tends to react differently – usually more dramatically - to changes in the stock price.

If calls are in-the-money (ITM) just prior to expiration, its delta will approach 1 and the option will probably move penny-for-penny with changes in the stock price. ITM puts, on the other hand, will approach -1 as expiration approaches. In this case, a 1 delta is similar to saying: there’s close to a 100% chance this option will expire at least one penny in-the-money.

That makes sense, right? If you have an XYZ 50 call, XYZ is trading at 53, and there’s only 1 day left before expiration, isn’t it very likely that this call will expire in-the-money? It’s already 3 points ITM now. XYZ would have to drop 3 points in a single day for this call to go OTM. In other words, that delta of 0.90 implies a very high probability of an ITM finish.

If options are OTM as expiration looms, both puts and calls will approach 0 more rapidly – in other words, it becomes more of a long shot that they’ll expire at least $0.01 ITM. Again, that zero delta makes more sense if you think of it as meaning “close-to-zero-chances” of being in-the-money at expiration.

In my next post, we’ll move on from delta and talk about another crucial concept for options trading that we first saw in the option chains: implied volatility. Stay tuned!

Catching up? Previous posts in the Options Guy’s back-to-basics 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 explained how to read an options chain, including key concepts like delta, open interest and implied volatility.

Next I unpacked “open interest” as an important measure of an option contract’s liquidity. We also introduced delta, one of the most popular “Greeks”, and explained how delta is dynamic.

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

[image: Triangle to the Sky by Kevin Lawver 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.  

Supporting documentation for any claims made in this post will be supplied upon request. Send a private message to All-Stars using the link below the profile image.

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.

TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.

(c) TradeKing, Member FINRA, SIPC. http://www.tradeking.com