Delta: Perhaps the Most Important Greek

02/04/2016 8:00 am EST

Focus: OPTIONS

Just as option prices are quoted on a per share basis, James Brumley of BigTrends.com explains how an options delta—citing an example to illustrate his point—is also priced on a per share basis.

Option trading is a nuanced art; option prices don't always move in a consistent, predictable manner. The so-called Greeks of option trading, however, explain how a put or a call option should change in price over time and in relation to changes in the pricing of the underlying stock or index. And, perhaps one of the most important Greeks an option trader should understand is Delta.

Delta is the amount of price change one can expect to see from an option relative to a $1.00 change in the price of the underlying instrument. Just as option prices are quoted on a per share basis (e.g. an option priced at $1.60 would cost $160 or 100 shares @ $0.60 each), an option's delta is also priced on a per share basis. For instance, a call option with a delta of $0.75 will increase by $0.75 in value—or $75 per contract—for every dollar that stock increases in value.

For a put option, delta is expressed in negative terms. That is, a put option with a delta of -$0.75 will lose $0.75 worth of value—or $75 per contract—for every dollar's worth of gain that stock achieves. Should the stock fall, as is the hope with a put option, that option would gain $75 per contract with every dollar the stock in question fell. [The positive or negative delta values are reversed for short positions.]

As an example, with General Electric (GE) trading at $28.64, a three-month call with a strike price of $20 sports a delta of $0.88 and costs $9.10 per contract. Based on those numbers, should GE shares rise to a value of $29.64, the option will theoretically rise to a value very near $10.00...up by $0.90, which is as close to $0.88 as possible as that particular option's trading increments will allow.

Conversely, a three-month put with a strike price of $31 has a delta of $0.92 and a price of $2.60. Should GE fall from $28.64 to a price of $27.64, the put option will theoretically rise to a value of $3.50 or approximately $0.92 higher as the delta value would suggest.

Generally speaking, the deeper in-the-money a put or call option is, the stronger the delta. The trade-off is, higher-delta, deeper-in-the-money options can be costly. Lower-delta options tend to cost much less, but they're not as responsive to price changes in the underlying stock or index.  For instance, using the GE example above, a three-month call with a strike price of $27 has a delta of only $0.71. It's a much cheaper option though, at $2.10. There's a much greater risk with the $27 call option, as a minor pullback in the value of GE shares could quickly take the call from in-the-money to out-of-the-money. But, in percentage terms, it's got much greater reward potential.

That being said... To read the entire article click here…

By James Brumley of BigTrends.com

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