This week we will talk a little about one of the “Greeks” – the variables 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 it 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 stock could fall by $4.90 or go up by any amount and it would end up being in the money, so the delta value would be quite high, maybe 70 or 75. The market would be saying that there is a 70% or 75% chance of the stock ending up above $55 at expiration.
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 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. We will talk about that phenomenon next week.