This week we will ignore the looming European debt crisis for a minute and talk a little about one of the “Greeks” – a measure designed to predict how option prices will change when underlying stock prices change or time elapses. It is important to have a basic understanding of some of these measures before embarking on trading options.
I hope you enjoy this short discussion.
A Useful Way to Think About Delta
The first “Greek” that most people learn about when they get involved in options is Delta. This important measure tells us how much the price of the option will change if the underlying stock or ETF changes by $1.00.
If you own a call option that carries a delta of 50, that means that if the stock goes up by $1.00, your option will increase in value by $.50 (if the stock falls by $1.00, your option will fall by a little less than $.50).
The useful way to think about delta is to consider its value to be the probability of that option finishing up (on expiration day) in the money. If you own a call option at a strike price of 60 and the underlying stock is selling at $60, you have an at-the-money option, and the delta will likely be about 50. In other words, the market is saying that your option has a 50-50 chance of expiring in the money (i.e., the stock is above $60 so your option would have some intrinsic value).
If your option were at the 55 strike, it would have a much higher delta value because the likelihood of its finishing up in the money (i.e., higher than $55) would be much higher. The 55 call might have a delta of 80 or 90 (or if the option is about to expire, it will approach 100). With the stock at $60 and the strike at 55, the stock could fall by $4.99 or go up by any amount and it would end up being in the money, so the delta value would be quite high.
On the other hand, if your call option were at the 65 strike while the stock was selling at $60, it would carry a much lower delta (maybe 10 if expiration is near, or 30 if there are a few months to go until expiration) because there would be a much lower likelihood of the stock going up $5 so that your option would expire in the money.
Of course, the amount of remaining life also has an effect on the delta value of an option. For in-the-money call options, the closer to expiration you are, the higher the delta value. For out-of-the-money options, delta values are higher for further-out expirations. As in many things concerning options, even the most simple measure, delta, is a little confusing. Fortunately, most brokers (especially thinkorswim) show you the net delta value of your long and short options at all times (or the deltas of any options you are thinking of buying or selling).
In one Terry’s Tips portfolio, we have sold December call options for AAPL which expire on December 16th. With the stock currently trading about $395, the Dec-11 395 call carries a delta of 50 (meaning the market is betting that there is a 50-50 chance of AAPL trading above $395 in two weeks, at expiration). We are also short a Dec-11 405 call which carries a delta of 30. The market figures that there is about a 30% chance that AAPL will be above $405 in two weeks. And the Dec-11 415 call has a delta of only 14, so the expectation is that 14% of the time, the stock might rally by $20 over those two weeks.