OUTSIDE THE BOX: Dissecting an Options Delta Attribute
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The Greek delta attribute is a gauge of the change in the price of your option relative to a change in the price of the underlying asset. Assume a trader purchased a call option on an underlying stock because he or she anticipates the price of this stock to rise. There is a distinct relationship between what is paid for the option, the current premium being asked for the option, and the price of the stock which has an option.
Keep in mind all of 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 options 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 attribute is calculated by dividing the amount of price difference of your option by the amount of price difference in the underlying equity. For instance, if the price of a stock option increased by .30 when the stock price went up .60, you would have a delta factor of .50 arrived at by dividing .30 by .60. 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, the higher potential for profits as the underlying stock moves. 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 very important that we always consider the risk-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 .10 would mean that, for every $1 increase in the value of the stock, the options premium would increase 10 cents.
The delta attribute is a measure to help you anticipate what options to purchase and when to sell the options you own. For example, let's say you're looking at two or three 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 stock and you should probably eliminate it from your list, unless you have a good reason for an extremely speculative play.
As you monitor the deltas of other options, you notice one becomes stronger and is outperforming the others. It is rising 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.
Start following the deltas of the favorite stocks that you trade and use them as a guidepost 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.
Happy Trading.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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