How Option Traders Use Delta

One of the first Greeks that traders often learn is delta because it is perhaps the most useful. On the one hand, it gives us an estimate regarding how much the value of an option will change as the underlying moves higher or lower. It can also be used to gauge the probability of an option expiring in the money.

Like the other Greeks, delta is computed using an option-pricing model and offers a theoretical estimate. Specifically, it tells us how much the value of an option contract is expected to change for each 1-point move in the price of the underlying stock. There are a few other ways to use the indicator as well.

Before looking at options, let’s first note that a stock has a fixed delta of 1. That’s because it will increase or decrease in value by $1 for every $1 move higher or lower in the share price. Meanwhile, call options have deltas ranging from 0 to 1 and puts have negative deltas of between 0 and -1.

Options with low deltas will see relatively little reaction to the move in the price of the underlying shares. However, options with deltas of 1 or -1 will see moves matching the price changes in the stock. For example, a call option with a .05 delta is expected to see a 5-cent change in value for every $1 move in share prices, but a put with a delta of -1 will see a $1 increase for every $1 drop in shares or a $1 increase for every $1 move higher in shares.

Professional traders also use delta to determine how more complex positions are likely to respond to changes in the underlying. This so-called position delta is especially important to market makers who need to create hedged positions that do not have much exposure to moves in the underlying stock. A simple example is to hedge 100 shares with two long -.5 delta puts. That is, since a stock has a delta of 1, two puts with -.5 deltas will create a position that is neutral with respect to delta, or 1 - .5 - 5 = 0. However, as the price of the stock changes, keep in mind that delta will most likely change also. Also remember that one put controls 100 shares and therefore two puts represents the right to sell 200 shares. A hedger wouldn’t necessarily need to exercise both puts if the price of the underlying falls.

A third way to use delta is somewhat unrelated to the first two. Specifically, the delta of an option can also be used as a thumbnail for that option contract expiring ITM. A call option with a delta of .5 has a 50% probability expiring in the money and a put with a delta of -.25 has a 25% probability expiring ITM.

Conclusion

Like the other greeks, delta is computed using an option-pricing model and offers only theoretical estimates. Nevertheless, as we have seen, the indicator can be used in different ways. It not only tells us how much the price of an option might increase or decrease, but also how more complex trades might change in value and delta is also as a thumbnail for an option expiring in the money.