Let’s Talk About “Deltas” for Options Trading

This podcast dives deeper into the lead greek and covers both a basic understanding of what delta is and how it works, plus some more high level insights into how I used delta to enter a trade in XLE.
Let’s Talk About “Deltas” for Options Trading
Kirk Du Plessis
Jan 22, 2018

One of the most popular and widely used options greek is Delta. And while I believe that you can't necessarily learn about option pricing and option greeks in a vacuum, as they all work together to represent potential price action for changing market conditions, having a solid understanding of how Delta works is important both in entering new positions and managing your basket of trades in a portfolio.

Key Points from Today's Show:

  • Delta is a big component of options trading.
  • At the very basic level, Delta is one of the four main Greeks used in options trading.
  • In options pricing, Delta does not predict where the market is going to go.
  • The Delta simply tells you how the option contract will react in pricing to different market scenarios.
  • Delta is exactly how much the option price will change if the stock moves up by $1
  • Delta is not constant and is always changing as it reacts to the market, making it useful for probabilities.

Example 1: If the stock goes up by $1 and you have an option contract that has a Delta of 0.5, then the option price will increase by 50 cents or $50. Now, if you have a Delta of 0.3, then if the stock moves up by $1 the options contract should increase (all things being equal) by 0.3 — another $30.

Example 2: If you have a put options contract with a Delta of -0.5, that means if the stock goes up by $1 your contract should go down in value by 0.5.

*Everything is related to the $1 move.

Understanding Delta

  • The key to understanding Delta is knowing what type of contract you have and where you want the market to go.
  • Delta will then help you understand the type of movement your contract will have relative to that $1 move.

Example: If the stock goes up by $10 and you have a Delta of 0.5, that contract will increase by $5. Then, if you have a Delta of -0.5 on a long put option and the market goes up by $10, the contract will go down by $5. If the value of the contract is only $4, then it will just go to $0.

  • If you think about Delta as the equivalent number of shares that you are holding in that security, it helps to simplify the concept of how pricing works.
  • If you have a Delta of 0.3, that is the equivalent of holding 30 shares.
  • A Delta of exactly 1, would be the equivalent of holding stock — 100 shares of stock.
  • This mindset helps you understand the price movement that you might see in the options contact based on where the stock goes in the future.

Options Selling

  • With option selling, you have to reverse your thinking in regards to Delta.

Example 1: If you have a short call option with a Delta of 0.3, it shows that you are exposed to bearish movements in the underlying stock -- 30 shares of equivalent holding value or risk if the stock rises.

Example 2: If you have a Delta of 0.2, this means that you are not as exposed to a huge run in the stock. If the stock runs up or makes a $1 move higher, then there is no as much exposure as if you had the 0.3 Delta call options.

Delta Options Trader Mindset

1. Using Delta as a rough approximate for the probability that a stock lands in the money.

Example: If you have a stock that is trading and the call option has a Delta of 0.3. That 0.3 could give you a rough approximate that there is a 30% chance that the stock lands in the money at the strike price, and a 70% chance the stock lands out of the money and never gets to the strike price by expiration. This creates a good benchmark for the probability.

  • When you are selling options, you can use these Delta's as a quick check or approximate representation of how likely you are to be successful selling those contracts.

Example: Selling a 30 Delta call option gives you about a 70% chance of success, and 30% chance of failure.As you get closer to expiration, the Delta of in the money options starts to increase and it starts to trade and react closer to how the regular stock would trade.

*Anything in the money at expiration converts to shares of stock.

  • Out of the money contracts start to see their Delta value decrease dramatically, as you get closer to expiration.

Example: With an out of the money call option, as you get closer to expiration, that call option is less and less likely to be hit. So the Delta value goes down, which also represents that there is a lower probability that the market rallies to that strike price or beyond by expiration.

  • As IV increases, it causes Deltas of out of the money options to increase.
  • This happens because market participants are assuming that the stock is going to make a big move.
  • As Deltas increase, this puts more weight on out of money options as it increases their risk of being hit.

Example: If you had an options contract that was $10 out or $15 out of the money, if there is a big move expected, now those contracts are back on the playing field. As the Deltas increase, this also increases the probability of the options to go in the money.

*Therefore, as an option seller, you do not want IV to increase.

2. Using Delta to calculate your portfolio balance.

  • Using Delta gives you a good representation of how balanced or unbalanced your portfolio might be, as a whole.
  • On most broker platforms, the software takes all of your Deltas and Betas of the underlying stock and concerts them to one big S&P position.
  • This shows you what your portfolio would look like if it consisted entirely of S&P, giving you one benchmark.
  • Giving yourself the ability to look at how your portfolio is tilted helps you build out more positions or remove positions that are risky, giving your portfolio more balance.
  • If for example, your Beta-weighted Delta's are extremely high, you know that you need to add some bearish exposure to your portfolio.

Example: If you Beta weight your portfolio and your portfolio has a Beta-weighted Delta of 7, that means for every $1 that the S&P goes up, it's estimated that your portfolio actually makes $7. This shows you that your portfolio has some bullish exposure because if the market goes up, that is generally good for your portfolio.

*If you have a large portfolio, a Beta-weighted Delta of 7 is not going to be that much. However, if it is a small portfolio, a Beta-weighted Delta of 7 might be high.

*The goal is to be as balanced to the market as humanly possible, all the time.

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