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The Delta

The Delta is a tool used in options trading. There have been some questions about this tool on the message board and in email so I thought we would address it tonight.  The Delta measures the change in an option's price relative to the change in the underlying stock price. 

If you know an option's Delta you can calculate how much money can be made on the option based on how much the underlying stock price moves. Call option Delta's are positive and Put option Delta's are negative.  This is because Call options have a positive relationship and Put options have a negative relationship with the underlying stock price movement. 

An example of this relationship follows:

A Call Delta of .50 indicates that for every 1 point the stock price advances you can expect to make .50 on your Call option.  If a Put has a Delta of .25 there would be a .25 drop in the Put premium for every 1 point the stock moved up.  For the sake of simplicity I will refer to the remaining examples as Call options but Put options are the inverse of all examples below. 

The higher the Call Delta is the more the reaction will be to the rise and fall of a stocks price.  Conversely the lower the Put Delta the larger the movement in the Put Option when the stock price moves up or down. 

You can buy options in three ways: in the money at the money or out of the money.  A deep in the money Call Option where the Strike price is much greater than the Exercise price will usually have a Delta of .90 or above.  This option will get you almost a dollar for dollar move in relation to the movement in the underlying stock price.  All options are risky but in the money options carry the least risk. 

An at the money Call option where the Strike price equals the Exercise price will normally have a Delta of about .50.  An out of the money Call option where the Strike price is less than the Exercise price will carry Delta's lower than .50.  A deep out of the money Call option where the stock price is well below the strike price will have very low Delta's. When option positions are deep out of the money and expiration is closing in their Delta's can be near zero and virtually worthless.  These of course will carry the most risk. 

Deep in the money options consist of almost all intrinsic value.  Out of the money options carry no intrinsic value instead the premiums are all time value.  Time value decreases drastically as the option gets closer to expiration. 

I have found from my experience in trading options that if I am buying out of the money options I want them to be at least six months from expiration the longer the better.  You will pay for time but time is what you need with these types of options.  If you buy out of the money options with only 1 or 2 months left before they expire the Delta will be so low that the option will not increase much even if the stock has a decent move up. 

Conversely when buying in the money options I want to buy them no more than two months out.  Any more than two months out and you will have to pay a time premium on top of the intrinsic value.  Time value is almost nonexistent for deep in the money options that are less than two months from expiration.  I use these as a trading vehicle only. 

Out of the money options carry the most risk while in the money options carry the least risk.  When buying in the money options you are just trying to make contact with the ball.  When buying out of the money options you are swinging for the homerun.  Like in baseball the harder you swing the more likely you are to strike out.  Deep out of the money options have no intrinsic value extremely small Delta's and very little chance of ever becoming in the money . Remember this: over 90% of all out of the money options expire worthless.  Buying those will result in many losses. However hitting just one homerun could make up for all the strikeouts. 

Options trading is not for everyone they are extremely difficult to trade successfully and if you are trading options without knowing the Delta you decrease your odds of success even more.







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