What Is Delta In Options?

Options contracts are proving to be extremely valuable for many investors these days. Effectively, options trading means you buy or sell these contracts. When you have a contract, you now have the right to buy or sell an underlying asset at a specific price within a specific timeframe. We won’t cover the different aspects of elements of options trading in this post, as it deserves its own separate guide.

Instead, this post will focus on something called Delta. Those of you that have begun an options trading journey may have come across this term before. What exactly does it mean and do you need to know about it? If you continue reading, we’ll answer all of your burning questions, helping you understand Delta in options and using this knowledge to make better trading decisions.

What is Delta?

Simply put, Delta is a risk measure that’s used by options traders. Essentially, it’s a way of managing the risks associated with a particular trade. In theory, this could help you run a risk assessment before doing any options trading, ensuring that you make the most informed and calculated decision. Often, the difference between great traders and good traders is that the great ones understand how to use risk measures more effectively.

What does Delta measure?

In other words, what is the purpose of Delta in options?

Well, this risk measure will estimate how much an option contract may change in value given a $1 increase or decrease in the value of its underlying security. You will be presented with a value, which is referred to as the Delta. This value can range between -1 and +1 on a scale. If the value is 0, it means the option has barely moved in value in relation to the price changes in the underlying security.

What are underlying securities?

In essence, all options are secured by underlying assets. This can be a stock or a commodity that basically determines the value of the options contract. The whole purpose of options contracts is to buy or sell the underlying security at a specific price at some point further in time. As such, the Delta represents an estimation of how much that options contract would be worth if the security increases or decreases in value by a dollar.

Understanding different Delta values

As briefly explained above, the scale of Delta values runs from -1 to 1. Therefore, you can have both positive and negative values. What determines this? It’s simple, the type of option you are trading.

If you are already getting into options trading, you’ll know there are two main types of options contracts: 

A put option gives you the ability to sell the underlying asset that’s linked to the contract at some point in the future for a pre-set price. Speaking in Delta terms, put options will always see a negative value on the scale - unless they are set to 0. This is because the value of put options will decrease when the value of the underlying asset increases.

Conversely, a call option lets you sell the asset in the future. Again, you will be able to buy it for a previously agreed-upon price at that point. On the Delta scale, call options will have a positive value. When the underlying security goes up in value, so does the value of a call option.

You also need to take ITM and OTM options into account.

ITM stands for in the money and it refers to options whose strike price (this is the pre-determined price you agree to buy or sell) has already been exceeded by the current stock price. Generally, an ITM option will end up with a higher Delta score than an OTM one.

OTM stands for out of the money and it’s when the strike price of an option has yet to be matched by the underlying security’s stock price.

The more in-the-money an option is, the higher its Delta score will be - and this is true for both call and put options. With call options, you’ll see a Delta score get closer to +1 depending on how in the money it is. For put options, the Delta score gets closer to -1 when it goes deeper in the money.

How do you use Delta in options trading?

Delta has many uses for an options contract trader. In this section, we’ll review some of the main ways you could use Delta when actively trading: 

Figure out the directional risk of your strategy

Generally, you have three major strategies to consider: 

A bullish strategy means you believe the asset will rise in price. Therefore, you want to have a long position in the market - this is usually referred to as being long the market.

On the other hand, a bearish strategy means you think the asset will decrease in price. As a consequence, you want to have a short position in the market or be short the market.

Finally, you have the neutral approach, which means you don’t really want to do either of the above.

Where does Delta fit into this? Well, when you look at the scale, it’s determined that short puts, long stocks, and long calls are all positive Delta values. At the same time, these are all seen as bullish strategies. So, if you calculate the Delta and determine it is positive, you should approach it with a bullish strategy to be the most successful.

Likewise, long puts, short stocks, and long calls are all negative Delta values. All of these are bearish strategies, so when the Delta is negative, you can take a shorter approach to your strategy.

See, Delta enables you to see which approach is the best one for you, so you understand which direction to go in to mitigate the risks.

See the chances of an option being in the money

If you recall earlier we spoke about options being in or out of the money. Being in the money is good as it means the strike price is close to what the actual asset’s value is. The cool thing is, we can use Delta to determine the probability of an option being ITM when it expires.

Remember, when the Delta moves closer to +1 or -1 it has a higher chance of being in the money for both call and put options. There’s a very simple calculation you can do to figure this out. If you have a call option with a Delta value of 0.7, it has a 70% chance of being ITM when it expires. If it sits at 0.2 Delta, then it will only have a 20% chance of being ITM.

As you can see, this is a very straightforward way of analyzing trading potential, particularly for call options. If a call option has an extremely low chance of being ITM when it expires, there is no point exercising your right to buy the underlying asset.

Look at how sensitive the stock is

The third and final way that most people use Delta in options is to see how sensitive the underlying stock is.

Now, this is where things can get a bit confusing, so bear with us.

We have established that an option moving deeper in the money will have a Delta closer to +1 or -1, correct? Let’s say the option has a Delta of +1. At this point, it is so in the money that it basically acts like the underlying stock, and its value moves with it.

Therefore, when Delta gets closer to +1 or -1, it means the option is more likely to be affected by the stock price. In essence, the stock becomes more sensitive as it moves the value of the option further than before.

Here’s an example: the underlying security increases by $1, what will this do to a call option with a 0.2 Delta and another with a 0.8 Delta? The 0.2 option will only move up in value by $0.20 while the 0.8 option goes up by $0.80.

As a result, using the Delta can give you a good indication of how much influence the stock will have on the option and how close the two values are to one another.

How do you calculate Delta?

There is a mathematical formula that traders use to determine the delta of different options.

It is written like this: Delta = (Of - Oi) / (Sf - Si).

What do all of these terms mean?

Of is the new value of the option.

Oi is the original value of the option.

Sf is the new value of the underlying security.

Si is the initial value of the underlying security.

While it initially looks a bit complicated, it’s actually rather simple. Those of you that are proficient in math will know that you handle the calculations in brackets first. So, you simply minus the original value from the new value of the option. Then, you minus the original value of the underlying security from the new value. This will give you two separate figures - one for the option and one for the security. Divide the options figure by the security figure and you get your Delta.

Of course, it’s always easier when you have an example, so here’s a very simple calculation to follow: 

Stock A is currently trading at $400 for each share. There’s a call option that has a strike price of $350 is trading at $30 - so, it’s ITM as the stock price currently sits above the strike price. Stock A now rises by $5 in price to $405. At the same time, the call option increases to $33. From here, we can easily calculate the Delta.

Start with the Of - Oi ($33 - $30) which gives you 3. Then, do the Sf - Si ($405 - $400) which gives you 5.

Next, you do 3 / 5 which leaves you with a Delta of 0.6.

You can use this calculation on any options contracts you’re trading.

What are the other risk measures in options?

You will encounter a host of different risk measures in the world of investing. However, options trading will have a very specific set of risk measures that are constantly used to see which trades are worthwhile or not. They are referred to as The Greeks - this is simply because they are Greek words.

If Delta is one of these risk measures, what are the others? 

Vega

Vega in options is a metric that measures the impact of a change in volatility.

Theta

Theta will look at the severity of a change in the time remaining on an options contract before it should be bought or sold.

Gamma

Gamma is the final risk measure and it works in conjunction with Delta. Effectively, it looks at the rate of change of the Delta.

Why is Delta important?

Delta is important because it helps you make sense of your options when trading. Without it, you wouldn’t be able to accurately assess the risk of trades. For instance, you might choose to exercise your right to purchase a call option when that really isn’t a wise decision at all. Figuring out the Delta can help you understand what decisions to make, increasing your profits and mitigating your losses.

Options trading can be a lucrative endeavor if you understand what you’re doing. For any of you that are interested in creating a consistent income through trading options, we can help with options trading ideas. Click here to find out more and see how it works. We use AI to help you make more informed decisions and get the best guidance around.

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