You may be familiar with the "Greeks" of option trading, the various indicators that describe option premium and risk levels. Among the Greeks, delta may be the most important and the one giving information that could be the most profitable.
Delta measures how option premium is expected to change with changes in the underlying stock's price. A higher delta tells you that option premium is likely to rise more in relation to rises in the stock price, just as a lower delta tells you the option will be less responsive. Delta may be thought of as a measure of extrinsic value, the third kind of value excluding extrinsic and time value. Extrinsic value is also the degree of implied volatility, and this is what delta is really all about.
Delta may be positive or negative, and overall delta is going to range somewhere between +1 and -1. A call has a positive delta, and a put has a negative delta because put premium increases when stock prices fall, and vice versa.
As you would expect, delta levels rise when a call gets closer to the money and then moves in the money (or for a put, the negative value increases). The delta is also likely to decline if the option moves further out of the money.
The proximity of the strike to current value of the stock is a primary influence of the delta. The second factor is time to expiration. When there is less time remaining, the odds that an option will remain in its "money state" (in or out of the money) also grows. So the closer the option is to expiration, the higher the delta for in-the-money and the lower the delta for out-of-the-money positions.
Recognizing the status of an option in terms of proximity between strike and current value, and also observing how that changes with time to expiration, is the starting point in determining whether an option's current premium level is reasonable. However, the real value to delta is found in noting how rapidly (or slowly) delta tends to change. As a rule, the delta tends to increase as it gets further in or out of the money (this acceleration is yet another Greek called gamma).
The rate of change is affected by proximity and time, and delta normally reflects this change. So an in-the-money call with a delta of 1.0 has a high likelihood of expiring in the money; in comparison, a call with a delta at or close to 0.0 has a very low probability of expiring in the money and is far more likely to close out of the money. Expanding this logic, delta of 0.5 indicates a 50% probability of being in the money at expiration.
The basic rule of delta remains:
- for long calls, delta is positive when the stock price rises.
- for short calls, delta is negative when the stock price falls.
- for long puts, delta is negative when the stock price falls.
- for short puts, delta is positive when the stock price rises.
Calculating delta and other Greeks is not difficult, especially given the numerous free online calculators traders can use. One of the best is provided free of change by the Chicago Board Options Exchange (NASDAQ:CBOE), where you can estimate all of the Greeks for any kind of long or short option. Go to tinyurl.com/6f39rnp to use the CBOE calculator.
Michael C. Thomsett is co-founder of ThomsettOptions.com and author of dozens of options and trading books. He also is an educator who teaches five courses at the New York Institute of Finance (NYIF). He also has arranged for a free download of a course from Ethan Hathaway introducing technical analysis, available at http://tinyurl.com/8qn4c9j