Delta: The King of All Option Greeks
03/06/2012 2:00 pm EST
More than the other option "Greeks," Delta has the biggest impact on trading profits and losses, says thinkorswim’s Joe Kinahan, who explains the proper way to use this critical measure.
Options traders of course are always watching the Greeks, but what are they, and what are the most important ones that option traders need to watch?
Our guest today is Joe Kinahan to talk about that. So JJ, talk about the most important, if you will, option “Greeks” that you like to watch.
Well the first one I think that everyone should watch is Delta. The textbook definition of Delta is how much an option moves with a $1 move in the underlying.
Another way to look at Delta is your overall position. That’s how I really like to look at it. For instance, at-the-money calls or at-the-money puts theoretically should have a 50 Delta. If I buy one call with a 50 Delta, I’m on 50 Deltas. However, if I buy ten, it’s 500 Deltas.
What does that really mean? The Delta is equivalent to how many shares of stock you own. So if I buy ten 50-Delta calls, it’s the equivalent of being long 500 shares of that underlying stock.
To use a stock example, McDonald’s (MCD): If I bought ten at-the-money calls in McDonald’s, I have 500 Deltas. Am I comfortable being long 500 shares of McDonald’s?
If the answer is yes, fantastic trade; if the answer is no, I shouldn’t be trading that many contracts of that Delta option.
So there’s a way to use it. That’s the one that changes most day to day because as prices of the stock change, so do the Deltas of the underlying calls and puts.
People also use Delta to find out what the chances are that it’s going to expire in the money or out of the money, right?
That’s a great point. You can also say that the Delta is a thumbnail probability of whether the option will expire in the money or out of the money.
A 50 Delta means there’s a 50/50 chance that it will be in the money on expiration day. If there’s a 70 Delta at that moment, there’s a 70% probability that option will be in the money on expiration day.
One thing to be careful of: "in the money" means worth one penny or more, so those options might be higher priced than that.
One that’s related very much to that is Theta. You know, I always joke that there are few things in life that are certain: taxes, death, and time decay. Options decay every single day, and Theta will tell you how much your option position (if you buy options) is going to decay against you. If you sell options, they decay in your favor. How much you collect or spend per day in options decay is what Theta measures.
Finally, Vega. You know, we always talk about volatility, and that’s the biggest factor in options pricing. All Vega truly tells you is what is your position’s reaction to a 1% move in volatility.
One thing to keep in mind: the closer you are to expiration, the lower the Vega number. The farther you are from expiration, the higher the Vega number for your options.
See related: Know Your Option “Greeks”
All right, so is there a way to kind of combine all three of these in the options chain to say “This is the option I want to buy?”
Well, I would say that Delta will be the one to pay the most attention to because it moves the quickest, and that’s probably the one people are very familiar with, equating it to how many shares of a stock they own.
That’s the one I would keep my eye on the closest because it will change the quickest and will have the quickest short-term effect—financially—on your position.