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When learning about options you will eventually come across the “Greeks.” The Greeks in respect to option trading are Gamma, Vega, Theta, and Delta. The option Greeks are essentially a set of measurements that explore the risk exposures of a specific options trade. The Greek Delta is probably the most fundamental and is certainly the first parameter that needs to be mastered by every beginning options trader.

Delta is a measure of the change in the price of your option relative to a change in the price of the underlying asset. Let’s say you have purchased a call option on an underlying stock because you are expecting the price of this stock to rise. There is a distinct relationship between what you paid for the option, the current premium being asked for the option, and the price of the underlying which you have an option.

The delta factor addresses questions like if the stock price increases by $1, will the premium of that option increase by $1? Remember all the factors that impact the premium price: volatility of the markets, traders’ expectations, the current price trends, amount of time until expiration of the option, the number of calls versus puts and whether the option is in or out of the money. Changes in an option’s premium will represent only a fraction of the change in the price of the underlying stock. Logic dictates there should very rarely be a higher demand for the option on a stock than there is for the stock itself.

The delta factor is calculated by dividing the amount of price difference of your option by the amount of price difference in the underlying stock. For example, if the price of your stock option increased by .20 when the stock price went up .40, you would have a delta factor of .50 arrived at by dividing .20 by .40. This means you would expect your option to increase at half the rate of the stock.

A delta factor of .50 is common when an option is very close to being in-the-money. The delta should never exceed 1. Therefore, the higher the delta factor is, the higher potential there is for profits as the underlying stock price moves. The opposite is also true. The higher the delta factor, the more expensive the option and the higher the loss can be for buyers.

This is why in options trading it is paramount that we always consider the risk to reward ratio. A low delta factor means that there is less of a cause and effect relationship between the option and its underlying stock. For example, a delta factor of .30 would mean that, for every $1 increase in the value of the stock, the options premium would increase only .30.

The delta factor is a gauge to help you anticipate what options to buy and when to sell the options you own. To begin with, let’s say you’re looking at three or four different options and you’re trying to decide which one to purchase. You start calculating the delta factors every day for a week or so. If an option has a very low delta factor, below .25, it may be deep out-of-the-money or in some other way has lost its relationship with the underlying market and you should probably cross it off your list, unless you have a good reason for playing a long shot.

As you track the delta factors of other options, you notice one become stronger or outperforming the others. It is increasing in value faster than the others. This is one reason for considering this option. It is definitely not the only reason. You must consider all the other elements that go into the calculation of the premium, which were mentioned earlier. Later on, when you’ve held your option for a while and have decided to offset it, you’ll want to look at the delta factor from a different perspective. Is it getting stronger or weaker? Knowing the trend of the delta factor of your option can sometimes help you make selling decisions.

Practice following the deltas of the favorite stocks that you trade and use it as a planning tool to enter and exit your option positions. Always keep in mind that delta factors are not stable. They change whenever the price of the option premium and the underlying stock change, which is almost constantly during trading hours. But these prices usually move in tandem, except when the option approaches expiration causing its time value to decay rapidly.

To read more about the Greeks, please see Platinum Toolbox: Trade Tools—What If? Part 2, by Jody Osborne, 2/11/2005.

Happy Trading.


Jeff Neal
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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