Trading is very slow today as many trading desks are closed in celebration of Veteran’s Day, so I thought it would be a good time to do an educational piece on a trading term known as Delta.
Delta is a ratio comparing the change in the price of the underlying stock to the corresponding change in the price of the option.
For example, if a call option has a delta of 0.70, this means that for every $1 the underlying stock increases, the call option should increase by $0.70. Conversely, if the stock were to fall by $1, the call option should decrease by $0.70.
For puts, the delta would be negative. For example, a put option with a delta of -0.70 will increase in value by $0.70 for every $1 the stock goes lower. Conversely, the put option would lose $0.70 of value for every $1 the stock rises.
In general, an option that is far in-the-money will have a delta near 1.00 and change in price similarly to the stock price. An option far out-of-the-money will have a delta closer to zero, and will not move much with the price of the stock.
Delta can also be thought of in terms of the likelihood that the option will finish in the money. For example:
With stock XYZ trading at 50, the approximate delta for the following positions would be:
XYZ November 35 Calls - 99 delta (This call will almost certainly finish in-the-money)
XYZ November 50 Calls - 50 delta (50% chance this call will finish in- or out-of-the-money)
XYZ November 65 Calls - 1 delta (This call will almost certainly finish out of the money)
What I described above is pretty cut and dry, but things get a bit more complicated when it comes to some of the inputs for figuring out the delta. Two of the most important inputs are time and volatility.
Time is also somewhat easy to understand. As I said, delta can thought of in terms of likelihood of an option finishing in the money. So with XYZ trading at 50, the January 55 Call would have a higher delta than the November 55 Call because the January option has a couple of months to finish in the money, and the November option has only a couple of weeks. In this hypothetical scenario, I would say the November options delta would be 10 and the January options delta would be 25.
Volatility is a bit harder to explain but I was watching one option in particular yesterday and I think it’s a good example. This option was the SPY January 195 Put. On the close of trade on Friday afternoon, the put was valued at $2.40 and it had a 22 delta. It was widely assumed that if the SPY rallied by one dollar the put option would lose $0.22. However, that did not turn out to be the case because volatility across the market, and in the SPY, was hit very hard yesterday.
With the SPY up $0.50 yesterday, we would have assumed--based on the 22 delta--that the option would have lost $0.11 (the stock moved half of one dollar so a change of half of the assumed delta). However, because of the volatility hit, the put actually lost $0.40. This is a great example of how important volatility is in the pricing of options. (Please note this was an exaggerated move for the price of this option; I do not generally expect similar price moves.)
Conversely, if the SPY had dropped, I’d expect volatility to rise, which would have made the option move higher in value than was expected.
As you can see, delta is a nice tool to use when gauging the approximate odds of an option finishing in the money as well as the “expected” move in the price of the option. However, as the example above shows, delta assumes a static environment, which we know is virtually never the case when it comes to the market.
Going forward, when I recommend a trade I will also present the delta of the trade so that you can continue to learn about this subject matter. Also, I’m fairly confident that nearly all online brokerage providers have the delta of each option available to you ... however, if you ever want to know about an option’s delta don’t hesitate to email me.