The Black-Scholes formula is the most common method traders use to calculate the value of the option. However, sensitivity remains a great concern to traders. If this resonates with you, options delta is the best solution for you. It is a greek that helps traders understand how the option value changes due to various changes.
Understanding Option Delta
Delta measures how option value is sensitive to variables such as interest rates, market prices, time to existent expiry, volatility, etc. It helps you understand how the option’s price will change in response to a given alteration in the underlying stock price.
According to Tastyrades, delta helps traders understand their directional exposure. You can also use it as a proxy to work out probability in-the-money (prob. ITM).
Assume you’re focusing on a Reliance 1250 call option that expires by the end of December 2021. Delta will measure how this particular contract’s option price moves with the variations in the cost of the Reliance spot.
Typically, the delta is higher for an in-the-money call option and lower in the out-of-money call option. Thus, an option delta of a call option often varies from 0 to 1, while that of a put option will range from 0 to -1.
For example, a delta of 0.8 shows that if the RIL stock rises by $0.02, the price of the call option will go high by $0.016. On the other hand, a put option with a delta of -0.8 will decrease by $0.016 since they negatively relate to the stock price.
How traders can make sense of Delta for trading options
Applying the delta relationships can increase your awareness of how you can hedge the risks and the probability of expiring in the money.
Different traders apply varying scales for measuring option delta. While some operate on a scale of 0 to 1, others prefer using a 0-100 scale. As a result, a value of 0.8 on some scales will record 80 in others. However, the concept beneath all the rankings is the same.
What traders must necessarily know about Option Delta?
• Deltas show the probability of your option expiring in-the-money (ITM). That’s why the delta of a deep ITM option is often close to 1, deep OTM approaching 0, and those of at-the-money (ATM) options always around 0.5 (indicating a 50-50 chance).
• Deltas always keep changing depending on factors such as volatility, interest rates, and maturity time.
• A rise in the stock price is always positive to call options but negative to put options.
• A positive delta indicates that you’re long on the market, while a negative delta shows you’re short on the market.
How can traders use delta for hedging their risk?
Delta hedging offsets long and short positions, reducing the risk of price variations in the underlying asset. For instance, if you hold a call option with a 0.50 delta, plus a put option with a -0.50, your net delta of the position becomes zero. And straddles typically have a zero delta.
Similarly, you can also do delta hedging with stocks and options. For instance, if the stock’s lot size is 1,000 shares, and you’re holding a call option delta of 0.90, selling 900 shares of the stock can help you hedge one lot of the call options flawlessly.
Delta is an essential greek to every trader. As a result, it pays to study how it works and apply to your trading.