Add the Options Delta to Your Trading Arsenal
The term “options delta” is one of what are commonly called “the Greeks” in option trading, but understanding its significance can make a big difference to your trading decisions.
In its simplest form, the delta is a number which describes the relationship between the movement in the price of the underlying financial instrument (stock, commodity, currency etc) and the option price that derives from it.
An example would be the “at-the-money” option. This refers to an option whose strike price is exactly the same as the current market price of the underlying. Whether we are talking call or put options, an at-the-money option always has a theoretical delta of 0.50 or 50 percent. The reason is, because from this ‘at-the-money’ position, the option contract has a 50/50 chance of expiring out-of-the-money. This is because in the future, the underlying will move one way or the other, up or down. It doesn’t matter which way it goes, the odds are 50 percent, or 0.50 each way.
Now, the further away from the strike price the underlying moves, if it causes the option to go ‘out-of-the-money’, the less likelihood there is, that the option contract will be of any intrinsic value at expiry date. So the delta decreases. Conversely, if the underlying moves in your favour, thus making the option contract ‘in-the-money’ the more likelihood there is that option will expire with some intrinsic value. So the options delta increases, but only to a maximum of 1.0 or 100 percent which indicates certainty.
Using the Options Delta in Trading Decisions
Now that you understand how the options delta works, you can use this to your advantage when assessing the potential risk of any trade. Let’s say for example, that you want to write a put credit spread over a stock index because you believe the index will either rise or at least remain above the strike price you have in mind by expiry date.
So you decide to sell put options at 100 points below the current index price and buy the same amount of put options at 110 points below, thus creating a 10 point credit spread. You observe that the options delta for the 100 strike price is 0.10 or 10 percent. This means that theoretically, there is only a 10 percent chance that the index is likely to fall below this level by expiry date. In other words, there is a 90 percent chance that you get to keep the credit.
So you enter the trade in the expectation that you have the odds 90 percent in your favour of a successful outcome. The delta has shown you this.
But let’s imagine that in the next two weeks, the index falls so that it moves closer to your ‘sold’ put strike price. This being the case, the delta will increase to reflect the new probability that the index will close below your chosen level at expiry date. So if the delta becomes 0.25 or 25 percent, this means there is now a 25 percent chance that the index will be below the sold strike price at expiry.
Understanding the options delta gives you a valuable tool to make option trading decisions. Some even say that the best and safest way to trade options is by adjusting your positions and “managing by the options delta”. This is particularly relevant when it comes to adjustable spreads such as credit spreads and iron condors. Managing your open positions by the delta is a more scientific approach which is a good thing – because after all, option trading should be just another way of doing business.