Understanding Delta In Options Trading

Posted by jbrumley on February 19, 2016 10:04 AM

Option Trading: What is Delta?

Option trading is a nuanced art; option prices don't always move in a consistent, predictable manner. The so-called "Greeks" of option trading, however, explain how a put or a call option should change in price over time, and in relation to changes in the pricing of the underlying stock or index. And, perhaps one of the most important Greeks an option trader should understand is Delta. 

Delta is the amount of price change one can expect to see from an option relative to a $1.00 change in the price of the underlying instrument. Just as option prices are quoted on a per-share basis (e.g. an option priced at $1.60 would cost $160, or 100 shares @ $0.60 each), an option's delta is also priced on a per share basis. For instance, a call option with a delta of $0.75 will increase by $0.75 in value -- or $75 per contract -- for every dollar that stock increases in value.

For a put option, delta is expressed in negative terms. That is, a put option with a delta of -$0.75 will lose $0.75 worth of value -- or $75 per contract -- for every dollar's worth of gain that stock achieves. Should the stock fall, as is the hope with a put option, that option would gain $75 per contract with every dollar the stock in question fell. [The positive or negative delta values are reversed for short positions.]

As an example, with General Electric (GE) trading at $28.64, a three-month  call with a strike price of $20 sports a delta of $0.88, and costs $9.10 per contract. Based on those numbers, should GE shares rise to a value of $29.64, the option will theoretically rise to a value very near $10.00... up by $0.90, which is as close to $0.88 as possible as that particular option's trading increments will allow.

Conversely, a three-month put with a strike price of $31 has a delta of $0.92, and a price of $2.60. Should GE fall from $28.64 to a price of $27.64, the put option will theoretically rise to a value of $3.50, or approximately $0.92 higher as the delta value would suggest.

Generally speaking, the deeper in the money  a put or call option is, the stronger the delta. The trade-off is, higher-delta, deeper-in-the-money options can be costly. Lower-delta options tend to cost much less, but they're not as responsive to price changes in the underlying stock or index.  For instance, using the GE example above, a three-month call with a strike price of $27 has a delta of only $0.71. It's a much cheaper option though, at $2.10. There's a much greater risk with the $27 call option, as a minor pullback in the value of GE shares could quickly take the call from in-the-money to out-of-the-money. But, in percentage terms, it's got much greater reward potential.

That being said...

Delta is not a static figure. In other words, it can change over time, and as a stock or index changes price. For that reason, it's not a perfect predictor of if-then price forecasts. Still, it may be the most important of the option Greeks, providing a trader with at least a basic if-then framework.

Another option Greek called Gamma measures the rate of change of an option's delta relative to changes in the price of the underlying price of the stock or index in question.

Option traders who prefer multi-legged positions can determine the delta (and gamma) of a spread or a so-called exotic trade by adding together the deltas of all the options in question, subtracting the negative deltas (including the positive deltas from short call options) from the positive deltas (and the negative deltas of short put options).