(2009-07-14) What is Delta?

This Answer Changed My Trading Life Forever (Part 1)

Learning about delta and using it to make better trades is not really complex, so
don't be intimidated.
Just remember the two most important things:

1) If you sell your stock and buy call options to replace it, then buy "in-the-
money" call options.

2) Only buy one call option for every 100 shares of stock that you own (or, would
want to own). In other words,
if you have 100 shares of Capital One Financial (COF), and want to close the
position at $21.60, you will have $2,160.
To establish an option position, you should buy only one call option contract
(which represents 100 shares).
If you buy the COF Jan 15 Call and pay $8 per contract (an $800 investment), then
you should put the remaining $1,360
in a safe, interest-bearing security, such as a money-market fund or Treasuries.

The "delta" of an option measures how much the option changes in price when the
underlying security moves one point.

The delta of a call option is a number that ranges from 0.00 to 1.00,
and the delta of a put option is a number that ranges from -1.00 to 0.00.

Hint: A call with a delta of 0.70 implies virtually the same thing as a put with
a delta of -0.70.

You will notice that when a call option is far out-of-the-money (for example, the
XOM Jan 95 Call is 30 points out-of-the-money),
(Let�s say that ExxonMobil (XOM) is trading at $65 per share, and the XOM Jan 65
Call is selling for $5.)
it will either move only slightly, or not move at all, when the stock rises by one
point.

The delta of this FAR out-of-the-money call is only 0.04. So theoretically, if XOM
moved up by one point, the price of the $95
calls should advance by 4 cents.

Now, that might seem like a lot in terms of the percentage gain since the
theoretical value of this far out of the money option
is about 27 cents. (A 4 cent gain would be a 15% gain on a 27 cent call option).
But you have to consider the fact that the
spread between the bid and ask price can be much larger than the 4 cent gain in
the option (so you can still end up with a
losing position).

*** The rule of thumb here is the higher the delta is, the more likely it is the
option ends up profitable. ***
And out-of-the-money options have the lowest delta, and in-the-money options have
the highest delta.
So you'd want to avoid the out-of-the-money option that has the delta of 0.04 like
the plague.

On the other hand, if the stock is trading far above the call option�s strike
price -- or, said differently,
the option is deep "IN-the-money" (i.e., the XOM Jan 45 Call, which is 20 points
in-the-money with the stock trading at $65),
then the call option would likely have a delta of 0.96.

Thus, when the stock moves up one full point, the option will likely move up 96
cents.
(Almost point-for-point, aka trading at "parity" with the stock.)

A put option would work the same way whereas, if XOM moved down one point, a PUT
option that has a delta of -0.70 would move up
by 70 cents.

2 Important Notes
1) An option�s delta changes as the price of the stock changes.
This is because the deeper in-the-money that an option becomes (due to the
price movement of the underlying stock,)
the higher the delta becomes.

So don't mistakenly think, if a call option has a delta of 0.50, that the
call option would only move up by 5 points
if the stock moves up by 10. That is incorrect because, again, the call
option's delta increases as the option moves
further above its strike price.

2) Today we are only discussing delta.

But an option�s price (and the option's delta) can be affected by other
factors.
The two major factors that impact an option's price and delta are
"time decay" and
a change in "volatility" of the underlying stock, Exchange-Traded Fund,
index, etc.

** Replacing Stock with Options vs. Gambling with Options **

No matter how much money you are putting at risk, the odds of success should be
good.
If odds favor a loss, why invest $1?

We must look at our investment portfolio as a business, and not a lottery ticket.

** Is Purchasing Out-of-the-Money Options Ever a Good Trade? **

No. More specifically, not if you're purchasing those options by themselves.
However, if you buy them as a hedge,
or as part of an multi-leg option position, that's a different story.

But today, we are talking about stock replacement, which just involves buying an
option instead of a stock.
I'm going to show you how to take less risk than the traditional stockholder.

First, you should understand that an out-of-the-money call option is an option

that has a higher strike price than the
current price of the stock. (With put options, it's the opposite. With puts, the
out-of-the-money options are those
with a strike price that is lower than the stock price. But let's stick with call
options in our examples.)

Many option traders lose money trading out-of-the-money options because they are
overly confident in their prediction.
For example: They may think a stock will trade from $65 to $80 in a given period
of time. But most of the time,
markets and stocks trade plus one or minus one standard deviation from the mean.

That is why "time decay" tends to be a factor that new, out-of-the-money option,
traders learn about very quickly (and painfully).

An out-of-the-money option�s delta will trend toward zero as time passes. And
remember, the lower the delta is,
the less the price of the option will be impacted by the movement in the stock.

Therefore, the underlying stock can trade much higher over time, but the call
option with a very low delta could still trade
lower, even to zero, even though the stock traded higher.

Trading with (what I consider to be) a Low Delta

The Low-Delta 'POSITIVE' Argument
A wise man once told me that the traders who make the HUGE profits like that
are the same ones that take LOTS of
huge losses.
The Low-Delta 'NEGATIVE' Argument
I usually don�t like to buy an option with a low delta unless I am covering
(hedging) myself against a significant stock
movement/loss. (Such is the case when using a protective put.)

There are two main reasons why, and both reasons spell a higher risk with
lower delta.
The first is one that most people understand;
the second is what many people overlook.

** 1) The lower the delta, the more extrinsic value your option contract
consists of. **
Remember: The extrinsic value (or time value) portion of an option is at the
mercy of the clock.
Time decay has zero effect on the intrinsic value portion of my options
premium. That's why we like to
trade in-the-money options that have minimal extrinsic value (time value).

By purchasing an option that has a high delta, I can significantly reduce

the effect that time decay has on
my option's value (or the option's premium).

** 2) Starting with a high delta reduces your loss when the stock moves in
the wrong direction. **
This is what an alarming number of option traders either don�t understand,
or only have a slight understanding of.

In other words, you stand to lose a lot less by owning the call option. This
is especially true when you are talking about
an option that has an expiration day further out than 90 days. (Remember,
90 days before expiration is when the extrinsic
value decay tends to speed up.)

NOTE: When you buy an option strictly for the upside (and you aren�t using
it for hedging purposes), you should always
give yourself extra time for it to work. Try to buy it with an expiration
month that is at least ***** 90 days *****
after the time that you wish to sell it.
 ***** Buy More Delta, Lose Less if Trade Goes South *****
When you buy options with a high delta (which are deep in-the-money) and the
stock trades lower,
your option loses less value than the stock does!

(2007-05-10) The Invaluable Understanding of Delta, (Part II)

I told you that by purchasing deep in-the-money options, you give yourself a high
delta, resulting in an option that
moves up in value more (point wise) than an option with a low delta as the stock
trades deeper and deeper in-the-money.

So, the deeper in the money you go, the more the movement in the stock�s price
will be reflected in the option�s price.
But that works on both sides, which is why you don�t want to go too far in-the-
money.

You have to have a balance between buying deep in-the-money calls, and still
staying relatively close to the strike price,
because if you buy a call that is too far in-the-money, you can not only make 98
cents on a 1-point gain in a stock,
but you can lose 98 cents on a 1-point loss in the stock.

What you want to do is position yourself so that if the stock moves up several
points, 85-90% of that gain will reflect
in the price of your call option, but if it moves down several points, you only
want more like 50 or 60% of the loss
reflecting in your option. How do we do this?

When I buy a call or a put option to open a trade (which is the most basic form of
options trading), I usually buy an option
that is anywhere from being ** 2-5 series ** in-the-money, depending on how *
volatile * the stock�s price is, and therefore
how much * time value * the option on the stock has. Usually the option that I
buy will have a delta of about ** 0.75-0.85. **

The idea is to buy an option that:

a) Has little extrinsic value (aka time value)
b) Will still give you a decent return
c) Has at least *** six months *** left before expiration

(2007-05-17) The Invaluable Understanding of Delta, (Part III)

Some people even think of the delta as being the probability of the option being
in-the-money at expiration.
(Delta of 20 indicating that there is a 20% chance of the option being in-the-
money at expiration.)

If you want to benefit from this feature, you should trade the options that have
at least 3 months left before
the expiration day. If you hold the Cisco options for a few months, and you
realize that expiration day will be in 3 months,
then what you should do is sell the calls that you own, and buy the calls with an
expiration day that's further out.
This way you can keep the feature of the call options gaining more and losing
less.

* Remember: Intrinsic value is the amount that an option is in-the-money.

Extrinsic value is the rest. *

"Extrinsic value", aka "time value" which was affected by all of the other factors
such as:
a) Time remaining
b) Volatility
c) The risk-free interest rate
d) Dividends that the stock pays.

These factors are also what affects the measurement called "delta".
The delta is not a factor. The delta is the conclusion or a result of the varying
factors mentioned above.

- An option contract with a lot of time remaining has a delta that changes rather
moderately as the underlying stock moves
from out-of-the-money to in-the-money.

- On the flip side, a short-term option�s delta will change dramatically as the
underlying stock moves from out-of-the-money
to in-the-money.

For the option that has a week left until expiration (very short-term,) the
option�s delta rises to nearly 1.00 very quickly
when it moves in-the-money. The option�s delta drops to zero very quickly when
the option moves out-of-the-money.

A SIDE NOTE:
Did you notice that the option with the most extrinsic value is always the option
which is at-the-money?
So if you were the seller of the option, in order to collect a premium in the case
of a covered call,
you would be taking the most advantage of time decay by selling the at-the-moneys.

The deterioration of extrinsic value known as time decay comes into play mostly in
the last three months remaining
on the life of the option contract.