Delta, one of the major Greeks, correlates the relationship between stock price and option value. Option traders use the Greeks to evaluate the risk inherent in our positions and Delta is a critical tool used to measure that liability. As we study the option literature, many of us have come across three related, but different, definitions of Delta and in this article we will explore those interpretations and relate them to our covered call writing and put-selling strategies.
Delta is the amount an option price will change for every $1.00 change in share price.
As an example, let’s say share price is $50.00 and the $50.00 call has a value of $2.00 and a Delta of .50. Now if share price rises to $51.00, the theoretical value of the option will move by $0.50 ($1.00 x .50) to $2.50. If stock price moved down to $49.00, the anticipated value of the $50.00 call decline by $0.50 to $1.50. Both scenarios assume all other factors remaining the same.
This definition helps us understand why our 20%/10% guidelines for closing our short calls works for all strike prices. In-the-money strikes have higher premiums due to the intrinsic value component but will decline in value faster because of the higher Deltas associated with in-the-money strikes. The option value will decline nearly dollar-for-dollar initially as share price decreases. Out-of-the-money strikes, which have the lowest total premium initially, decay the slowest because these strikes are associated with the smallest Deltas as highlighted in the screenshot below:
Delta and the Moneyness of Strikes
Delta is the equivalent number of shares represented by the options position.
As an example, if an option has a Delta of .60, one options contract would represent 60 shares of stock, as each share has delta of 1, by definition. This definition is often associated with a concept known as the Hedge Ratio where stock is traded against option positions. For example, if we buy 10 call contracts with a Delta of .50, we would be long 500 Deltas. To create a Delta-neutral portfolio (little or no market risk) we would have to sell 500 shares of stock.
This definition is especially meaningful as it relates to strike price selection. When we are writing covered calls, we are long the stock and all shares have Deltas of 1. When we sell the call options, we are short the calls, leaving us in a Delta-positive position as our options generally have Deltas less than 1. The higher the overall Delta of our position, the greater our exposure to market risk. By selling high-Delta options (in-the-money strikes) we are limiting this market risk, lowering the amount of our total positive Deltas position and therefore increasing the hedging we are seeking in bearish or volatile market conditions. In bull markets, we would favor low-Delta options or those out-of-the-money.
Delta is the percentage likelihood that, upon expiration, the option will expire in-the-money or with intrinsic value.
As examples, an option with a Delta of .85 has an 85% chance of expiring in-the-money and an option with a Delta of .10 has a 10% chance of expiring in the money.
This definition is especially useful to those of us who want to avoid our shares being sold if we are employing covered call writing or having shares sold (put) to us if selling cash-secured puts. In both cases, we would favor low-Delta options or out-of-the-money calls and puts. The deeper out-of-the-money we go, the lower the Delta and the less our exposure to potential exercise.
Delta defines the relationship between share value and option pricing and can be viewed from at least three perspectives. The most commonly-accepted definition is the first one presented in this article: Delta is the amount an option price will change for every $1.00 change in share price. However, also having an awareness of and understanding the other interpretations will be quite useful in establishing our option-selling decisions.
For more detailed information on the Greeks:
1- Complete Encyclopedia- Classic version: pages 156 – 166
2- Selling Cash-Secured Puts: Pages 195 – 211
April 26, 2016
Global stocks rose this week led by energy- and commodity-sensitive companies. The Chicago Board Options Exchange Volatility Index (VIX) dropped a bit from 14.36 to 13.22. Crude oil prices rose to $43.39 from $39.77 a week ago. This week’s reports and international news of interest:
- Saudi Arabia refused to freeze oil production without Iran’s participation, while Iran elected not to participate in the talks in Doha, Qatar
- Chinese stocks trading in Shanghai have rebounded from the low on January 28th (adding 12%)
- Chinese stock trading in Hong Kong (Hang Seng China Enterprises Index) have returned about 22% since the lows in mid-February. Concerns about currency stability and slower economic growth have been alleviated for now
- US jobless claims fell to the lowest level since 1973
- New claims were only 247,000 versus a consensus of 265,000. Although this is the lowest level since 1971, the size of the labor market is much larger today than it was over 40 years ago. The fact that employers are holding onto their employees appears to be a good sign for the labor market
- ECB holds key interest rates unchanged at 0.0%, 0.25% and -0.40%, respectively. ECB president Mario Draghi warned that inflation may turn negative in the coming months
- Emerging market nations cut interest rates
- Over the past few weeks, the central banks of India, Indonesia, Turkey, Taiwan and Hungary have all lowered policy interest rates in an attempt to improve slow economic growth
- Brazil moves closer to impeaching Rousseff as the nation remains in recession and political strife
- In the largest emerging market bond offering to date, Argentina has raised $16.5 billion. This comes after the country defaulted on more than $80 billion in debt in 2001
- Weak Q1 results raise worries over future bank profits. Five of the largest six US banks missed their earnings target in the first quarter. In addition to lower levels of trading desk revenue, the low interest rate environment has impacted net interest rate margins
- SunEdison’s Chapter 11 filing: ED has lost about 99% of its stock market value since last summer and owes creditors nearly $10 billion. The company continues to deal with five failed deals with a combined value of about $3.8 billion. At least two of these deals are in the renegotiation or litigation process
THE WEEK AHEAD
- US new homes sales are reported on Monday, April 25th
- US durable goods orders are announced on Tuesday, April 26th
- The FOMC meets on Tuesday and Wednesday, April 26th – 27th
- US GDP is announced on Thursday, April 28th
For the week, the S&P 500 rose by 0.52% for a year-to-date return of 2.33%.
IBD: Uptrend under pressure
GMI: 5/6- Buy signal since market close of March 2nd
BCI: Moderately bullish, favoring out-of-the-money strikes 2-to-1. A mixed second week of earnings season with some major tech stocks disappointing. Market held up well despite this.
Wishing you the best in investing,
Alan ([email protected])