Trading with Delta, Explanation of the Options Greek

Options trading usage of Delta

trader using options delta to see how one market reacts to another
FotoSearch

Delta (Δ) is one of the options greeks which are collectively used to determine how closely an options contract tracks its underlying market. Specifically, delta is the rate at which the price of an option contract will move compared to the price of its underlying market. Delta is one of the most commonly used options Greeks.

What Delta Values Mean in Options Trading

A call option will have a delta value between 0 and 1, while a put option will have a delta value between 0 and -1.

The value reflects how much the option moves for every $1 of movement in the underlying asset. For example, if a call option has a delta of 0.5, it means that the option price will increase $0.50 for every $1 increase in the stock price. A 0.9 delta means the option rises $0.90 for every $1 increase in the underlying asset. The buyer of a put option makes money if the underlying asset goes down, which is why put delta values are negative, but the concept is same.

Typically delta can be thought of as a percentage, as opposed to a momentary number. For example, a delta of 0.6 means the option price will see about 60% of the movement compared to the underlying asset price.

Since options prices (both puts and calls) can be affected by both up and down price movements in the underlying asset, it is beneficial to know the delta for both up and down movements in the underlying asset. For example, if the underlying asset rises $1, delta may be 0.7.

But if the underlying asset falls $1 the delta may be 0.5. In other words, the option price is more sensitive to price increases than it is to price declines. The opposite could also be true. A number of factors can cause this, including how far in or out of the money an option is, volatility and time until expiration.

Why Delta Values Change

The delta value of an option will change for a number of reasons. 

Time will affect delta, because time brings the option closer to expiry. As an option nears expiration, options that are near the money or in the money will see their delta values increase, because close to expiration that option should move very similarly to the underlying asset (see What are In the Money and Out of the Money Options).

For options that are out of the money, and not close to being in the money, the delta value will decrease toward 0. With almost no time till expiration, if the option isn't close to being in the money, there is little reason for traders to buy it, and therefore the movements in the price of the underlying asset will have less and less affect on the option price (unless it gets to close being in the money).

Volatility also affects delta. Volatility increases the chances of an option moving into the money, therefore out of the money options tend to see an increase in delta as volatility increases. In the money options have a tendency to see their delta value decrease as volatility moves up.

Uses for Delta in Trading

Delta can be used as a way to estimate profits on options positions, based on how much the underlying asset moves.

Delta is also used in hedging, and can show how many options contracts are needed to attain or hedge a position in the underlying.

For example, if a stock options contract (gives the right to one hundred shares) has a delta of 0.77, the option price will behave as if it were only seventy seven shares of the actual stock. Delta is therefore often used to determine the number of options contracts that must be traded in order to replicate a specific number of shares. If a trader wants to trade five hundred shares of XYZ using an option with a delta of 0.71, they would need to trade the equivalent of seven hundred and four shares, or seven options contracts. This is calculated as:

(Desired share position / option delta) / 100 = Number of options contracts

In the case above, that works out to: (500 / 0.71) / 100 = 7 options contracts.

Keep in mind though, delta does change over time. Maintaining an option position that approximates 500 shares may involve buying more or selling some of your options contracts over time. 

Final Word On Options Greek Delta

Delta is useful for seeing how the option price moves relative to the underlying asset price. This can help establish how much your option may be worth based on how much the underlying asset moves. It is also useful for estimating how many options you need to buy or sell in order to establish a replicated position (specific number of shares) in the underlying asset.