When studying option trading basics and the Greeks we learn about our exposure to risk. Those of us who study options are constantly reading and hearing that delta, one of the Greeks, is one of the most powerful influences over option value. Because of this, I thought it prudent we discuss this subject in greater detail.
Delta measures the amount an option price will change as a result of a $1.00 price change of the underlying security (stock, ETF). Other major factors that impact option value include the price of the stock, implied volatility and time to expiration. Since call options rise and fall directly with the price of the stock, they are assigned deltas between 0 to1.
Look at delta as a bet: What is the percentage chance that the option will end up in-the-money (lower than the market value of the stock) or be exercised by expiration Friday? The higher the delta value the greater the chance of this happening. A delta of .9 or 90%, for example, means that the strike price will almost definitely end up in-the-money. In the scenario where we sold a $50 call and the stock was trading @ $70 with one week remaining, the delta would be at or near 1 and for every $1 change in the price of the stock; the option will also change by approximately $1. This is typical of deep I-T-M strikes.
For at-the-money strikes, deltas will be closer to .5 or 50%. In this scenario, for every $1 change in the price of the underlying, the option value will change by $0.50, reflecting about a 50-50 chance that the strike will end up I-T-M.
For deep out-of-the-money strikes, deltas would be quite low, between .1 to .2 or 10% to 20%, for example. If we sold the $50 call and the stock was trading @ $30, the chances of that $50 strike ending up I-T-M are quite low. If the stock price moves up or down by $1 the option value will change by perhaps .10 because of the low delta.
The chart below summarizes the approximate deltas for the 1-month options we sell when writing covered calls:
Delta values increase as the strike moves further I-T-M and decrease as the strike moves deeper O-T-M. This can be visualized in the graph below:
Delta, strike price and stock price
Delta vs. Strike Prices
Factors influencing delta:
1- Stock price– As we can see from the above figures, an increase in stock price (red arrow) moves the strike towards I-T-M status and the delta will increase.
2- Time– Delta will change as we approach expiration Friday. I-T-M strikes will show increasing deltas because of the higher likelihood of ending with intrinsic value (less time to move O-T-M). O-T-M strikes will show decreasing deltas because of the lower likelihood of turning things around and ending up I-T-M.
What delta teaches us about risk when selling covered call options:
We learn why O-T-M calls present more risk. These calls have low deltas. If the stock drops in value, the option price will decline at a much slower pace (because of the low delta). This will make it more expensive to buy back the option if we are looking to institute an exit strategy and/or close our position.
Deltas measure the probability of an option ending I-T-M, or stated differently, with intrinsic value:
- I-T-M strikes- highest deltas
- A-T-M strikes- deltas near 50% or .5
- O-T-M strikes- low deltas
Strike selection based on delta:
- I-T-M strikes- if bearish or conservative as option premiums will decline faster with decreasing share price making it easier to close our positions.
- A-T-M strikes- for maximum premium return.
- O-T-M strikes- if bullish so option premium AND share appreciation can be realized.
Understanding the relationship of delta to our option premiums will make us sharper investors as it will allow us to select the best strike price for a given situation.
Next live event:
American Association of Individual Investors- Chicago Chapter:
Saturday, November 10th
10AM to 11:30 AM
This was a light week for economic reports but good news on the real estate front:
- Sales of new homes rose by 7.8% in August
- The median price of existing homes rose to $187,400 in August, the first time prices have increased for 6 straight months since December, 2005 to May, 2006
- The time needed to deplete entire inventory of homes fell from 6.4 months to 6.1 months
- Construction of new residential homes rose by 2.3% in August as housing starts are 29% higher compared to a year ago
- The Conference Board’s index of leading economic indicators fell by 0.1% in August as anticipated. The index is still up 1.5% compared to a year ago
IBD: Confirmed uptrend
BCI: Cautiously bullish using an equal number of in-the-money and at-the-money strikes. I am not as confident in the upcoming earnings season as I have been the past year.
Thanks for your incredible support.