Delta and the Moneyness of Options

05/05/2015 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman, of TheBlueCollarInvestor.com, explains the ins and outs of one of the most important Greeks when it comes to options; delta. Not only does Alan highlight several key definitions, but he also includes a chart that illustrates the relationship between the moneyness of options and delta.

Understanding and mastering the Greeks are key factors in becoming an elite covered call writer and put-seller. In this article, I will focus on delta, one of the important Greeks, as it relates to the moneyness of options (in-the-money, at-the-money, or out-of-the-money). Let’s start with a review of a few definitions:

Definitions

Greeks: They are numbers generated by mathematical formulas resulting in ways of estimating the risks associated with options, such as the risk of the stock price moving up or down, implied volatility moving up or down, or how much money is made or lost as time passes.

Delta: The amount an option will change in value for every $1 change in share price. The greater the chance of the strike ending up in-the-money, the greater the delta. Delta values run from 0 to 1.

Moneyness of Options: Describes the relationship between options strike price and the price of the underlying security and determines if intrinsic value exists in an option.

chart
Click to Enlarge

We can see that out-of-the-money strikes have deltas under .5, at-the-money strikes have deltas at about .5, and in-the-money strikes have deltas above .5. The deeper out-of-the-money the strike, the closer the delta is to 0 and the deeper in-the-money the strike, the closer deltas are to 1.

Delta and the BCI Covered Call Writing 20/10% Guidelines

The 20/10% guidelines are among the most important BCI principles relating to position management for covered call writing. It sets a guideline as to when to buy back an option (close the short option position) when the price of the underlying security drops in value. Since we generate more total premium (not necessarily more time value) for an in-the-money strike, the fact that the delta is higher than for an out-of-the-money strike, premium value will erode faster due to delta and allow us to close the short position in a timely manner should share value decline. The smaller total premiums generated from at-the-money and out-of-the-money options will erode slower also due to delta, and therefore, keep us from closing our positions too soon.

Why Aren’t the Deltas for Exactly At-the-Money Strikes Exactly .5?

This is more a point of interest rather than a concept that will influence our trading strategy. Generally, a call option will have a delta slightly greater than .5 for an exactly at-the-money strike and a put option will have a delta slightly under .5 in that scenario. This relates to interest rates which make the call more valuable as option buyers can control shares of stock at a lower price and leverage the saved cash to earn interest. The greater the time until expiration, the greater the call delta will be in relationship to the put delta. Again, this is an interesting (perhaps not?) fact and I present it to you in case you get an options question on Jeopardy (even Alex wouldn’t know this one).

Summary

The impact of delta, which erodes the value of pricier in-the-money strikes quicker than cheaper out-of-the-money strikes, is responsible for allowing the BCI 20/10% guidelines to have universal application for all strike prices.

***Puts show negative deltas because as share price rises, put values decline.

By Alan Ellman of TheBlueCollarInvestor.com

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