The Important Greek Word Every Options Trader Needs To Know…

When you’re trading options, it’s important to keep in mind that they are derivatives. This means they trade based on the price action of an underlying security. So, understanding how option prices will react to changes in the underlying security is critical.

At first glance, option pricing can appear relatively simple. The price of a call option increases or decreases as the underlying stock (or ETF) goes up or down. (The price of a put option increases as the underlying stock’s price falls and decreases as the stock rises.)

The primary driver of option prices will always be the action in the underlying stock. But there are a lot of other factors in play. Volatility, time decay, and interest rates also affect option prices, among other forces.

Let’s take put selling, for example. With this strategy, you need to estimate the potential return and the amount of capital at risk. Our primary means for doing this is derived from assuming a worst-case scenario (when the puts are assigned.) You would then determine how much capital would be at risk if you were required to buy the underlying stock.

This assessment is helpful for option contracts that are converted into a stock position. But it doesn’t help us understand where an option contract will be trading before the assignment takes place.

That’s where delta – arguably the most important of the options “Greeks” comes into play.

Delta — The Primary Measure of Option Price Movement

The options Greek delta refers to how an option contract reacts to a $1 movement in the underlying stock. The values range from 0 to 1 for call options and 0 to -1 for put options.

For example, a call option with a delta of 0.5 would be expected to increase $0.50 for every dollar the underlying stock rises. If a call has a delta of 1, the price would move in lockstep with the underlying stock price.

A put option with a delta of -0.5 would be expected to increase $0.50 for every dollar the underlying stock fell. And a put with a delta of -1 would move in line with the underlying stock price.

Delta is calculated for individual option contracts. It’s typically available as part of any standard brokerage platform, option charting site, or quote service.

The important thing to realize is that delta can change rapidly depending on the dynamics of a specific option contract. The two primary factors affecting delta are how far in or out of the money an option is trading and how much time is left until expiration.

In the Money vs. Out of the Money

For most of us, the majority of put contracts that we sell are out of the money. This means the strike price for the put option is below the current stock price. The stock price must fall before we become obligated to purchase shares.

Delta decreases (moves closer to zero) for option contracts the further they are out of the money. This is because options significantly out of the money have a much lower probability of being exercised. So, the less likely the put contract will be exercised, the less it is worth in absolute terms, and the less it matters if the stock moves up or down by a small amount.

In contrast, the further in the money an option contract is, the higher the delta. (Closer to 1 for a call or -1 for a put.) It also means it will trade more in line with the stock. If the stock is trading well below the strike price of your put contract, there is a high probability it will be exercised.

Of course, if the stock trades fairly close to the strike price, there will be uncertainty as to whether the option will be assigned. This is when it is essential to pay attention to the options delta to determine how much the underlying option contract will react to a change in the stock price.

The following table illustrates the point with a fictional “XYZ” stock trading at different prices in relation to its call and put options at the $75 strike price:

Amount of Time Until Expiration

The second important factor affecting delta is how long the option contract has until expiration. If an option is set to expire very soon, then there will be much more certainty.

In this case, if the option is out of the money, its nominal price and delta will naturally migrate toward zero as expiration approaches. Because the option is unlikely to be exercised, it has very little value. Therefore, a small fluctuation in the underlying stock price won’t greatly affect that value.

If the option is in the money, the delta will naturally migrate toward 1 (call) or -1 (put) as time runs out. This means pricing for the option contract will fluctuate more in line with the underlying stock. The probability of the option being converted into a stock position is very high.

All else being equal, the longer until an option expires, the lower the delta measurement will be. This is because a small fluctuation in the day-to-day pricing of the stock does not necessarily have a significant effect on the long-term expectation for the stock.

So, from a timing perspective, delta is higher when there is less time until expiration and lower when there is more time until expiration.

Putting Delta Into Practice

Keep an eye on the delta of your option contracts. It helps you know what to expect in terms of profit and risk from your positions.

For example, when selecting a put option to sell, the closer the delta is to zero, the more likely the put will expire worthless. This allows you to keep the premium without buying the underlying stock.

Let’s say you sell a put, and the delta for the contracts rises unexpectedly. This can be a good signal to closely examine your position to ensure everything is still trading as expected. In this scenario, you are more likely to have the put contract assigned.

If you’re familiar with selling puts, you know this doesn’t have to be bad. But only if you’re selling puts on stocks that you wouldn’t mind owning at that price. Monitor the situation carefully if the stock breaks down for an unexpected reason.

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