Using Delta to Predict Option Prices
11/28/2011 10:15 am EST
Delta is regarded by many as the foremost of all option “Greeks” and can be used to gauge the degree of expected price movement for an option, provided that other pricing factors remain constant.
I’ll make it short and sweet for MoneyShow.com readers today.
We all know options are derivatives, and their prices are derived from the underlying stock, index, or ETF. But with other factors at work—implied volatility, time decay, etc.—how can you know how much an option is going to move with respect to said underlying? Very simple…check out its Delta.
See related: Yet Another Use for Option Delta
Delta is arguably the most heavily watched option “Greek,” as it offers a quick-and-dirty way of telling what to expect from our option positions as we watch the price action of the underlying. Calls have positive Deltas, as they typically move higher on a rise in the stock; and puts have negative Deltas, as they typically move lower when the stock rises.
While some investors view Delta as the percentage chance an option has of expiring in the money, it is really more of a way to project expected appreciation or depreciation. A Delta of 50 for a call suggests the option should move 50 cents higher when the stock jumps a dollar, and in turn, the option should lose 50 cents for every dollar loss in the stock.
But Delta is only foolproof when all other factors hold static, which is rarely the case (and certainly never the case for time decay). If an option is moving more (or less) than its Delta would suggest, it is likely because other variables are shifting.
For example, buying demand might be pushing implied volatility higher, raising the price of the options. Still, this king of all Greeks is a good starting point for gauging how your options are likely to move.
Find out more about how I trade options using Delta here.
By Dan Passarelli of MarketTaker.com