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How to Trade Options » EXPLAIN OPTION TRADING » Options Delta

Options Delta

Add the Options Delta to Your Trading Arsenal

The term “options delta” is one of what are commonly called “the Greeks” in options trading, but understanding its significance can make a big difference to your trading decisions.

In its simplest form, the delta is a number that 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 that 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 the option’s expiration date. So the delta decreases. Conversely, if the underlying moves in your favor, 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

Options DeltaNow 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 the expiration date. In other words, there is a 90 percent chance that you get to keep the credit.

So you enter the trade with the expectation that you have the odds 90 percent in your favor 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 the expiration 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, options trading should be just another way of doing business.

 

The Options Delta – Video Version

options delta

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Filed Under: EXPLAIN OPTION TRADING Tagged With: delta neutral trading, delta options greek, explain the options delta, options delta trading, options greek delta, what is the options delta

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DISCLAIMER: All stock options trading and technical analysis information on this website is for educational purposes only. While it is believed to be accurate, it should not be considered solely reliable for use in making actual investment decisions. This is neither a solicitation nor an offer to Buy/Sell futures or options. Futures and options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed in this video or on this website. Please read "Characteristics and Risks of Standardized Options" before investing in options. CFTC RULE 4.41 - HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVERCOMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.