The Importance of Options Delta

Delta is an option Greek and one of the major keys to options trading profitability. Understanding what Delta is and how to use it can really increase your odds of options trading success. Unfortunately, no one really talks about it. You rarely, if ever, see it in financial newspapers like the Wall Street Journal or through talking heads on television. So we’re going to take the time to explain Options Delta and how you can profit from it.

Why Delta is Important

Delta essentially measures how much your option will increase or decrease in value based on the underlying price change of the stock.

How Delta Works

The definition of Delta as it applies to options is the percentage an option will increase or decrease in value in relationship to the underlying stock.

As an example: A Delta of .40 or 40% means the option will move or change in value equal to 40% of the underlying stock’s price. In practical terms, for a $1 rise in the stock, an investor should expect a 40 cent rise in the option premium. If the stock fell by $1, the option premium should fall by 40 cents.

Delta is simple to understand on the outside, but there is a second part to it that may appear confusing.

Here’s the second part:

Delta is NOT Constant

Delta will change based on how in-the-money or out-of-the-money your option becomes.

As an example: Let’s say a stock is trading at $75 and you own the out-of-the-money call option at the $85 strike price with 6 months until expiration. The options has a Delta of .45 or 45%. Let’s also say that the call option is priced at 6.00 which is $600.

Now let’s say the stock increased $10 to $85 and your call option is now currently sitting at-the-money. That means in that $10 underlying price move, your option just gained the value of 4.5 or $450 due to its .45 Delta.

Important Note: As your option gets further into the money, your Delta will increase up to 100%. The same is true for the opposite. As your option gets further out-of-the-money, you Delta will decrease up to 100%.

So now that our underlying is trading at $85, the call option might now have a Delta of .68 or 68% as opposed to the original .45 or 45% that it had when it was trading at $75. The Delta increases because the underlying is further in-the-money. If that stock were to increase another $10 to $95, then the option premium would increase another 6.8 or $680.

To Reiterate This Concept: The Change in Delta is Not 1-to-1

A problem some option traders have is not grasping the idea that the rate of change of Delta is always varying.

For example: You own an underlying stock at $75 that has an ATM call premium price of $500. Let’s say the underlying price drops $10 to $65. The call premium is now worth $410. If the underlying price gains $10 back to the original $75, the call premium will probably be around $460 because the Delta would be much smaller during the upswing.

The difference in premium occurs because on the way down, as the stock loses price, the option premium was losing at a higher percentage rate due to the high Delta. When the stock went back up, the option was gaining a slower rate due to the smaller Delta assigned to the trade since it was further out-of-the-money when the move was made.

This is why some traders can be right on the underlying stock direction, but not right on the option itself.

How Do I Use Delta To My Advantage?

Pay attention to Delta because it tells you how much you are looking to make (or lose) from your starting point.

You have in-the-money, at-the-money, and out-of-the-money options. Although we don’t recommend buying single options (they’re too risky), a lot of folks opt to purchase out-of-the-money options because they are very cheap and you could load up on them. This is a mistake in our book.

Out-of-the-money options have very small Deltas. For your option to be profitable, it requires a large underlying price move in your favor. If the stock remains stagnant, trades within range, or gradually moves, the chance of profiting from the option trade decreases tremendously due to the small Delta. Not only will the option premium remain stagnant, you will have to battle time decay.

Options in-the-money and at-the-money will naturally have a higher Delta and experience a larger move in premium price if there was a large move in the underlying price. Even with small moves in the underlying, there’s a higher chance for your option trade to become profitable.

For this reason, Delta is one of the major keys to becoming a successful options trader.