First of all, don’t be frightened.
The options Greeks should not scare you away. Quite the opposite. For those serious about trading options, the Greeks will give you far greater insights into your position, portfolio, etc., while allowing you to manage risk on the fly.
I’m not going to cover everything today. I plan on taking a more methodical approach. I only want to do a quick summary today and will follow up with a more detailed discussion on each Greek over the next few weeks.
Of the four predominant Greeks used in options trading, delta is probably the most important Greek as it can be used in a variety of different ways.
The first way that I use delta is by thinking about probabilities.
For instance, if you buy a stock, the probability of a stock moving higher is 50% (actually 1% to 2% higher if you include the risk-free rate). In the world of options this type of situation would be equivalent to buying an at-the-money call or put option.
The S&P 500 (SPY) is currently trading for 469.40. As a result, the at-the-money strike is 469 and as seen below, the associated delta of the 469 call is just over 50% at .51. The probability of success is 51.33%. What does that tell us? It tells us that there is a 51.33% chance that SPY will close above the 469 call strike at expiration in 39 days. Essentially a coin flip.
So, the first way delta is used by options traders is to find out what the probabilities are on the trade. Since we are typically selling options, we want to use a delta that is typically lower than .50. For example, if I sell an option with a delta of .20, my probability of success on the trade will be roughly 80%.
You can see an example of this below. By choosing the 484 call strike our delta is .21, which means our probability of success is 80.18%. So again, the delta essentially tells us what the probability of success is on the trade. By knowing this we can alter our strike to either bring in more/less premium and simultaneously decrease/increase our probability of success on our prospective trade.
But that’s not all delta tells us.
Delta also represents the change in price of an option contract for a $1 move in the underlying asset. For example, if you have a SPY option worth $1 with a delta of 0.60 and the underlying ETF moves $1 higher, all things being equal, the options contract now has a value of $1.60.
If we look at the image above, the 484 call strike with a delta of .21 is worth roughly $2.04. If SPY were to move $1 higher, all things being equal, the 484 call contract would now be worth $2.25.
Essentially, delta provides insight into how options premium will respond as your underlying stock of choice moves up or down. Knowing this information gives you a good idea how much money you stand to make, or lose, based on a specific move in the underlying stock.
But the real beauty of delta is that it tells you exactly, in real time, what the market anticipates for a specific price being reached at expiration. No technical or fundamental data required, just hard statistics which is always a quantitative trader’s preference. The market sets the probabilities based on a variety of factors which I will discuss in a subsequent post. Just know that the foundations of these probabilities are based on how real money is being traded, not conjecture.
No speculating on geopolitical concerns, inflation rates or upcoming Fed speak. Everything is already priced into the option, based on real-time supply/demand, again in real time.
I will be delving even deeper into delta over the coming weeks as I begin to put out a series of videos on the topic and other options-related topics. Until then you should have a good base knowledge on why delta should be the anchor of all of your options trading, especially when using options selling strategies.