What's the "Delta" of That Happening?

08/15/2012 9:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Dan Passarelli takes a common option "Greek" and explains it in a way that any investor or trader can relate to.

Apple (AAPL) sure is making a lot of news lately. The company recently reported earnings and subsequently fell in price. Since the fall, the stock has once again moved higher.

One may expect the AAPL stock to push higher (after this dip), but some may believe the rebound will be still short-lived. Perhaps a smart move is to purchase a short-term, out-of-the-money option on the equity—let’s look for an option with a delta greater than 20 on Apple and see how the option could play out.

Option Delta and the Trade
First, let’s define option delta before we go into the option play. Option delta is a ratio that compares a stock’s change in price to the corresponding price change in said stock’s option. For this example, we are going to use the Apple September 650 call that has about an option delta of 23%.

What does the 23% mean? Let’s convert the option delta into dollars to see. This percentage means that this particular Apple option will gain or lose value just like 23% of 100 shares of Apple as the price changes. Look at the definition this way if it is easier: for every $1 Apple advances, the call option will increase 23 cents attributable to delta.

So, Apple is currently trading at around $605 (rounded for simplicity) and we have purchased the 650 call. We need the call to advance past $650 (which is not out of the question) in order for the option to be in-the-money. But can we benefit from a rally that falls short of $650?

The Benefit of Option Delta
Apple is a major momentum stock. Just look at what happens after good news—more often than not, the stock rallies. In fact, I don’t think it is a stretch to say that the stock often moves quite a bit. Look at 2009, when Apple dropped as low as the $78 region in late January, then rallied to finish the year above $210. That is a major gain.

Playing the September 650 call affords a trader the chance to make money in the case that the stock rallies. If the stock hits $650, that means it has moved 45 points. Take the 45 points and multiply that by 23 cents (option delta of .23) and you have a move of $10.35 in the call (45 x 0.23).

By looking at the option delta, we were able to have clear expectations for option profit based on stock movement. Does this mean that playing the delta is a foolproof way to analyze an option? No.

There are other important pricing factors that affect the value of an option, too. Time (theta), volatility (vega) and more also play an important role. Delta is just one of the greeks that can be taken into account when looking for the right option to purchase. Make sure to do your homework so you can enter the option game prepared to succeed.

It is standard trader lingo on the trading floor:

  • “What’s your delta of making it to the party tonight?”
  • “What’s the delta the broker comes back and buys more of these?”
  • “I’m about 90 delta I’m going to dump Sheila tonight.”

Option traders have probably used the word delta in this context every single day of their life, and if you learn to trade options like a professional, you may too.

It’s the “traders’ definition” of delta—that is, delta is the likelihood of an option expiring in-the-money. Though this definition actually has a few mathematical shortcomings, making it not entirely technically correct, every professional option trader I know thinks about delta this way. And, in turn most traders borrow the concept of delta being the likelihood of success to adopt into their everyday speech.

The idea is every option has an associated delta figure attached to it. Like, at the time of this writing, the Apple September 655 calls have a 0.25 delta. Yes. That means that they change in value 25% like the underlying stock. But it also is interpreted by traders to mean that the AAPL September 655 calls have a 25% chance of expiring in-the-money.

This practical use of delta helps guide traders’ expectations and helps them make better trading decisions by factoring probability into their decision-making process. I encourage traders to think about option delta this way. You should start today. I’m 100 delta that you’ll be glad you did.

Dan Passarelli can be found at MarketTaker.com.

Related Articles on OPTIONS